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    What Is A 'Currency Swap'

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    Shubham Phophalia

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    What Is A 'Currency Swap'

    Uploaded by

    Shubham Phophalia
    93 views11 pages

    Original Title

    Swap Introduction

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    93 views11 pages

    What Is A 'Currency Swap'

    Uploaded by

    Shubham Phophalia

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 11

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    Currency Swap
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    What is a 'Currency Swap'


    A currency swap, sometimes referred to as a cross-currency swap, involves the
    exchange of interest and sometimes of principal in one currency for the same in
    another currency. Interest payments are exchanged at fixed dates through the
    life of the contract. It is considered to be a foreign exchangetransaction and is not
    required by law to be shown on a company's balance sheet.

    BREAKING DOWN 'Currency Swap'


    A currency swap can be done in several ways. If there is a full exchange of
    principal when the deal is initiated, the exchange is reversed at the maturity date.
    Currency swap maturities are negotiable for at least 10 years, making them a
    very flexible method of foreign exchange. Interest rates can be fixed or floating.

    Background
    Currency swaps were originally done to get around exchange controls. As
    most developed economies have eliminated controls, they are done most
    commonly to hedge long-term investmentsand to change the interest rate
    exposure of the two parties.
    Pricing is usually expressed as LIBOR plus or minus a certain number of points,
    based on interest rate curves at inception and the credit risk of the two parties.

    Exchange of Principal
    In a currency swap, the parties agree in advance whether or not they will
    exchange the principal amounts of the two currencies at the beginning of the
    transaction. The two principal amounts create an implied exchange rate. For
    example, if a swap involves exchanging €10 million vs $12.5 million, that creates
    an implied EUR/USD exchange rate of 1.25. At maturity, the same two principal
    amounts must be exchanged, which creates exchange rate risk as the market
    may have moved far from 1.25 in the intervening years.

    Many swaps use simply notional principal amounts, which means that the
    principal amounts are used to calculate the interest due and payable each period
    but is not exchanged.

    Exchange of Interest Rates


    There are three variations on the exchange of interest rates: fixed rate to fixed
    rate; floating rate to floating rate; or fixed rate to floating rate. This means that in
    a swap between euros and dollars, a party that has an initial obligation to pay
    a fixed interest rate on a euro loan can exchange that for a fixed interest rate in
    dollars or for a floating rate in dollars. Alternatively, a party whose euro loan is at
    a floating interest rate can exchange that for either a floating or a fixed rate in
    dollars. A swap of two floating rates is sometimes called a basis swap.

    Interest rate payments are usually calculated quarterly and exchanged semi-
    annually, although swaps can be structured as needed. Interest payments are
    generally not netted because they are in different currencies.

    Trading Center
    Swap Rate
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    A swap rate is the rate of the fixed leg of a swap as determined by its particular
    market. In an interest rate swap, it is the fixed interest rate exchanged for a
    benchmark rate such as LIBOR plus or minus a spread. It is also the exchange
    rate associated with the fixed portion of a currency swap.

    BREAKING DOWN 'Swap Rate'


    An interest rate swap is the exchange of a floating rate for a fixed rate; a
    currency swap is the exchange of interest payments in one currency for those in
    another. In both types of transaction, the fixed element is referred to as the swap
    rate.

    Read More +

    Bond Market Association


    (BMA) Swap
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    A type of swap arrangement in which two parties agree to exchange interest


    rates on debt obligations, where the floating rate is based on the bond market
    association's swap index. One of the parties involved will swap a fixed interest
    rate for a floating rate, while the other party will swap a floating rate for a fixed
    rate.

    BREAKING DOWN 'Bond Market Association (BMA)


    Swap'
    The benefits of two parties entering into an interest rate swap arrangement can
    be significant. Often, each of the two firms involved has a comparative advantage
    in its fixed or variable interest rate. Consequently, for budgeting or forecasting
    reasons, a company may wish to enter into a loan with a fixed or variable interest
    rate in which it does not have a comparative advantage.

     
     

    Delayed Rate Setting Swap


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    An exchange of cash flows, one of which is based on a fixed interest rate and
    one of which is based on a floating interest rate, in which the spread (difference)
    between the fixed and floating interest rates is determined when the swap is
    initiated but the actual interest rate is not determined until later. The swap
    contract will define the amount of time the investor has to lock the swap's fixed
    interest rate.

    BREAKING DOWN 'Delayed Rate Setting Swap '


    A delayed rate setting swap is also called a "deferred rate setting swap" or
    "spread lock". This type of interest-rate swap might be desirable if the investor
    expects interest rates to change in its favor in the near future but likes the spread
    currently available. Once the fixed interest rate has been set, a delayed rate
    setting swap acts like a regular interest rate swap.

    Interest Rate Swap


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    Video Definition
     

    An interest rate swap is an agreement between two counterparties in which one


    stream of future interest payments is exchanged for another based on a specified
    principal amount. Interest rate swaps usually involve the exchange of a fixed
    interest rate for a floating rate, or vice versa, to reduce or increase exposure to
    fluctuations in interest rates or to obtain a marginally lower interest rate than
    would have been possible without the swap.

    BREAKING DOWN 'Interest Rate Swap'


    A swap can also involve the exchange of one type of floating rate for another,
    which is called a basis swap.

    Read More +
     
     

    Liability Swap
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    An exchange of debt related interest rates between two parties - usually large
    corporations. In a liability swap, two currently identical (in nominal value) cash
    flows are exchanged. Usually a variable (floating) rate is exchanged for a fixed
    rate of income. Swaps are undertaken because each company receives a better
    rate of interest by trading with the other than they would if they chose a more
    traditional financing route.

    BREAKING DOWN 'Liability Swap'


    For example, XYZ may swap a six-month LIBOR interest rate for ABC's six-
    month fixed rate of 5% on a notional principal of $10 million dollars. Due to the
    split, XYZ will pay a fixed interest payment of 5%, instead of the floating rate.

    A swap will have an initial value of zero because the initial cash flows are the
    same. Over time, however, this will change as interest rates change and the
    swap will have either a positive or negative value for each contract holder. In
    certain cases, the swap can be marked-to-market periodically to clear out the
    unrealized gains and losses by making any payments due.

    Foreign Currency Swap


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    A foreign currency swap is an agreement to make a currency exchange between


    two foreign parties. The agreement consists of swapping principal and interest
    payments on a loan made in one currency for principal and interest payments of
    a loan of equal value in another currency. The Federal Reserve System offered
    this type of swap to several developing countries in 2008.

    BREAKING DOWN 'Foreign Currency Swap'


    The World Bank first introduced currency swaps in 1981 in an effort to obtain
    German marks and Swiss francs. This type of swap can be done on loans
    with maturities as long as 10 years. They differ from interest rate swaps because
    they also involve principal.

     
     

    Asset Swap
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    An asset swap is similar in structure to a plain vanilla swap, the key difference is
    the underlying of the swap contract. Rather than regular fixed and floating loan
    interest rates being swapped, fixed and floating investments are being
    exchanged.

    BREAKING DOWN 'Asset Swap'


    In a plain vanilla swap, a fixed libor is swapped for a floating libor. In an asset
    swap, a fixed investment such as a bond with guaranteed coupon payments is
    being swapped for a floating investment such as an index.

    Interest rate swap


    An interest rate swap is an exchange of future interest receipts. Essentially, one
    stream of future interest payments is exchanged for another, based on a
    specified principal amount.

    Each participant in the swap is referred to as a party, or together,


    as counterparties.

    Financial institutions use interest rate swaps to manage credit risk, hedge
    potential losses, and earn income through speculation.  While interest swaps are
    very complex, they allow financial institutions and corporations to manage debt
    and risk more effectively.

    The most common type of interest rate swap is the vanilla swap.  In a vanilla
    swap, one party – the payer – agrees to pay a fixed-rate interest, while the other
    party – the receiver -- agrees to pay floating-rate interest, which is usually tied to
    the London Inter-bank Offered Rate (LIBOR).  Note that the counterparties do not
    swap their actual investments, or their entire interest payments. They simply
    agree to make payments to one another based on the rise or fall of the floating
    interest rate. 

    There are potential benefits and risks for both parties in an interest rate swap. If
    interest rates rise, the payer benefits, because their fixed rate is unchanged, and
    the receiver now owes them the difference between the fixed rate and the
    floating rate. If interest rates drop, the receiver wins, because their floating rate is
    now lower than the fixed rate, and they will be receiving the difference from the
    payer.

    Read more: Interest Rate Swap - Video |


    Investopedia http://www.investopedia.com/video/play/interest-rate-
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