Financial Swaps. Two firms in two different markets may have relative strengths in borrowing in two different currencies. Swap is an arrangement whereby a firm borrows in the currency in which it has advantage and exchanges the liability with another firm for an equivalent liability (at the time of the agreement) in another currency. For the same currency, the relative strengths of the firms may be with regard to the payment of interest.
One firm may have advantage in borrowing at fixed rate of interest, while the other in floating rate. (Where the borrowing is at fixed rate, the rate of interest payable is the same throughout the currency of the loan. Under floating rate, the rate of interest is linked to a benchmark rate such as London Interbank Offered Rate or LIBOR and is revised every six months by reference to the LIBOR then prevailing.)
Therefore the swap may involve borrowing at floating rate and exchanging the liability for payment of interest with another firm borrowing at fixed interest rate. It is also possible that both currency and interest factors affect the choice for going for a swap. Based on these swaps are classified into three types as follows:
Firm A in New York can borrow in dollars at 6% and in pound sterling at 9%. Firm B in London can borrow in dollars at 8% and in sterling pound at 7%. Firm A needs GBP 1 million which it can repay in 3 years. Firm B needs similar value in US dollars. If both the firms raise the needed funds in the market, firm A has to pay interest of 9% and firm B interest of 8%. It would be to their mutual advantage if firm A raises the loan in dollars at 6% and firm B in sterling pound and they exchange their liabilities.
The arrangement would be as follows:
(i) On the date of the contract, firm A raises a loan of USD 1.6 million (assuming the spot rate to be GBP 1 = USD 1.6) and remits the amount to firm B. Firm B raises a loan of GBP 1 million and remits this amount to firm A.
(ii) Periodically, say every six months, firm A calculates interest on sterling liability at 7% and remits this amount to firm B to enable it to pay the interest on the sterling loan. Similarly firm B remits interest in dollars to firm A at 6%.
(iii) On maturity firm A remits GBP I million to firm B to adjust the loan raised by the latter. Similarly firm B remits USD 1.6 million to firm A.
In practice the arrangement may not be directly between firm A and firm B, but the transaction may be intermediated by a financial institution dealing in swaps.
Interest rate swaps
Firm C and Firm D, both at London, are rated differently by the market and offered loans at different rates. Firm C can raise loan at 10% fixed or LIBOR plus 0.5%. Firm D can borrow at 11% fixed or LIBOR plus 0.75%. Although firm D has disadvantage both under fixed and floating rates of interest, it has comparative advantage under floating rate where the differential is only 0.25% as against 0.5% under fixed rate. Suppose that firm C wants to raise loan under floating rate and firm D would like do so under fixed rate. It would be to their mutual advantage if firm C raises the loan at the fixed rate of 10% and exchanges the obligation for payment of interest with firm D which raises the loan at LIBOR plus 0.75%.
It should be noted that under interest rate swap the loan liability is not exchanged; only the periodical payment of interest is exchanged. The loan amount becomes the notional value based on which the interest is calculated.
In the above example, firm C may exchange the fixed interest liability at a
rate slightly higher than the actual cost, say at 10.25%. Firm D may have to offer
the exchange at a rate lower than its cost, say at LIBOR plus 0.25%. The net effect
is that firm C is able to borrow at LIBOR, a gain of 0.5% and firm D borrows at
10.75%, a gain of 0.25%. The rates at which the rates are exchanged depends upon the relative bargaining capacity of the parties.
An interest rate swap is known as the coupon swap where the liabilities exchanged are involving fixed and floating rates of interest. In a basis swap the interest rates involved are both floating, but on a different basis, for instance, one may be linked to LIBOR and the other to treasury bill rate.
A coupon swap should not be confused with Zero Coupon Sawp. A zero coupon swap is a special type of swap where one ofthe counterparties makes a lumpsum
payment instead of periodical payments over time. The lumpsum payment can
occur at any time, up-front, at maturity, or during the life of the swap.
Cross-currency interest rate swap. This is a combination of currency swap and interest rate swap. For instance a US firm which can borrow cheap dollar funds at floating rate may exchange the liability with a UK firm which borrows sterling funds at cheaper rates at fixed rates of interest.