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Swap as a Financial Market Product

Also View connected Articles under Derivatives Products

1. Foreign Exchange Derivative Products in India

2. RBI Regulation on Foreign Exchange Derivatives Contracts

Swap, as mechanism for widespread use is a development of recent origin during the last two decades. This is due to the progressive elimination of exchange and capital controls and the revolutionary developments in telecommunication and computer technology, active 24-hour trading in foreign exchange has emerged. As a result of these innovations the process of liberalisation and consequent integration of markets is under way. The high volatility of exchange rates and interest rates have opened up opportunities for large profit to market participants in the spot as well as in the forward markets, provided they are on the right side of the market. Trading is now increasingly guided by new decision techniques, particularly chart-based by sell recommendations, rather than considerations of the underlying economic factors as hitherto done. Such a move towards sophistication and globalization of markets in turned opened up arbitrage opportunities, which are increasingly availed through swaps and options in an effective manner.

The most commonly used types of Swaps are currency and interest rate swaps. The currency swap began in 1981, while interest rate swap started in 1982. Currency Swap. A Currency swap enables contracting parties to exchange predetermined streams of payments denominated in another currency during an agreed period of time. Two types of Currency Swaps are commonly transacted:

1. Fixed/fixed Currency Swap ((both terms ‘fixed’ refer to interest rates)

2. Cross currency Interest Rate Swaps.

In this type of swap contracts, fixed interest payments on a specified principal amount of one currency is swapped for fixed interest payment on an agreed equivalent principal amount of another currency. Unlike in the case of interest rate swap, where principal currency amount being in the same currency and therefore not exchanged on the final maturity exchanged, in a currency swap the principal amount may be exchanged on the final maturity date of the swap contract at pre-determined exchange rate. Sometimes the principal amount in the respective currency may be exchanged initially and then re-exchanged at the maturity of the contract.

An example will make clear the elements of fixded/fixed currency swap clear. Suppose Party A agrees to pay a Swap Bank 0 percent interest in Dollars payable at half-yearly rests for a three year period on a principal amount of $ 100 million. In return Party A received 5% interest in DM, on DM-180 Million payable half yearly during the 3-year contract period (the DM equivalent is calculated at the spot $/DM rate, say DM 1.00). On each 6 monthly interest payment date, A pays $ 4 million to Swap Bank and received in return DM 4.5 million. At the end of the 3-year period Party A pays $ 100 million to the Swap Bank and received DM 180 Million (at the agreed exchange rate of $/DM at 1.80

There are four main elements in a fixed/fixed currency swap.

1. There are fixed interest payments on due dates in the respective currencies.

2. There are specified principal amounts in two currencies on which interest payments at the specified interest rates are calculated.

3. There is an exchange rate involved. In this case it is the spot rate on contract date. It can even be a mutually agreed forward rate. The same exchange rate is used for computing the principal amount for calculating the interest payments and also for the exchange of principal on the initial date and re-exchange on the maturity date of the swap contract.

4. There is a specified maturity period.

Often a currency swap may involve exchange of one currency at fixed interest rate in return for receipts on a floating interest rate on another currency during the contract period. This is termed as Cross Currency Interest Swap. The transaction works on the same way as fixed/fixed currency swap, except that one of the currencies involved will carry a floating interest rate in exchange for the fixed rate in the other. Similar to the fixed rate currency swap, cross currency interest rate involves a final exchange of principal at the agreed spot exchange rate (or at agreed forward rate) prevailing on the date of the swap contract. Most of the cross currency interest swaps involve the swapping of fixed rate deutsche mark or Swiss franc or Japanese Yen against floating (interest) rate US Dollars.

An interest rate swap is a transaction in which two parties agree to exchange interest payments on an underlying notional amount but carrying interest payments based on differing terms according to agreed rules, It is important to note two points:

1. There is no exchange of principal amount either initially or on maturity, as the notional principal amount is the same, And

2. On each interest payment date, only the net amount will be paid/received by the counterparties.

There are three types of interest rate swaps.:

1. Coupon swaps:
   A coupon swap is a fixed or floating rate interest swap in which two parties exchange fixed interest payments with floating interest payments on an underlying principal amount denominated in the same currency. For example Party A agrees to exchange Fixed Interest rate at 10% on $ 10 million for floating interest rate based on 6 months LIBOR for $ 10 million with a swap Bank for a period of 3 years.

2. Basic Swaps:
   A basic swap involves exchange of interest payments calculated on different terms, such as 6 month LIBOR and prime rate (or triple A commercial paper rate).

3. Cross currency Interest swaps:
   In this type of swaps exchange of payment on different currencies is involved. For example Dollar 6 months floating rate with fixed yen interest rates for a specified period on equivalent not notional principal amounts, or fixed rate dollar with fixed rate yen.