Swaps
A swap as the name implies, represents an exchange of obligations. Swaps are agreements on the line of "I will pay for you, if you will pay for me". The swap rate is the cost of exchanging one currency into another for a specified period of time. Normally, swaps are of two types, i.e,. Interest rate Swap and Currency Swap.
Interest rate Swap (IRS):
Interest swap is a contract which commits two counter parties to exchange over an agreed period, two streams of interest payments. For example, exchanging floating interest and fixed interest payments. Only interest is exchanged in the swap, there is no exchange of principal. IRS is used, when a company can borrow with one type of financing (being advantageous) but really prefers another.
Parties may enter into Swap contract directly or through an intermediary often called as Swap Bank Usually, an intermediary interposed between the two parties. It passes: the both streams of interest payment & retains some margin called as swap commission. Interest rate swap will materialize if, only if, cost of financing after swap (including swap commission) remains lower as compare to that cost of financing which borrower has to incur, had he opted his desired stream of interest payment at inception.
For example:
A Ltd. B Ltd.
(a) Borrowed Amount Rs. 50, 00,000 Rs. 50, 00,000
(b) Interest Rates:
-Fixed 11% 9.5%
-Floating Prime Rate + .75% Prime Rate
(c) Willingness: Fixed Rate Floating Rate
(d) Prime Rate: 10% 10%
(e) Swap Bank's Commission .10% .15%
How the Swap Contract Operates:
A Ltd. will borrow floating rate debt & B Ltd. Fixed rate debt being cheaper as compared to other type of borrowing. However, A Ltd. is interested in fixed rate debt & B Ltd. in floating rate debt. They may enter into swap contract through an intermediary say, swap bank.
Swap bank will pay fixed interest @ 9.5% to B Ltd., which B Ltd. will pass on to it's lender to meet out it's original interest liability.
B Ltd. will pay to swap bank whatever it has received from swap bank + swap commission but in changed stream i.e. (Prime Rate -.35%). This arrangement converts B Ltd's fixed interest liability in floating interest liability and cheaper as compared to such liability (Prime rate) which B Ltd. has to incur, had it opted floating rate debt at inception.
Swap bank will pay (Prime rate + 0.75%) to A Ltd., which A Ltd. will pass on to it's lender to meet out it's original interest liability.
A Ltd. will pay to Swap Bank whatever it has received from swap bank + swap commission but in changed stream i.e. 10.85%. This arrangement converts A Ltd's floating interest liability in fixed interest liability and cheaper as compared to 11 % fixed interest liability, had A Ltd. originally opted for fixed interest rate debt.
Hence, it appears that above swap arrangement had proved advantageous for all the 3 parties involved in this arrangement.
In case of floating interest stream, benchmark interest rate (e.g. LIBOR, Prime Rate, PLR etc) is very significant. Whether a swap transaction could be materialized or not, depends upon such benchmark interest rate. Hence in such cases, first, we have to find out benchmark interest rate (if not given in the problem) on the basis of data given in the problem and after that swap arrangement would be designed.
Currency Swap:
In a currency swap, the two payment streams being exchanged are denominated in 2 different currencies. Usually, an exchange of principal amount at the beginning and re-exchange at termination are features of currency swap. The principal amounts are equal the currency market rate. In order for swap to work, it is essential that the principal amount be of the same value.
Example:
(a) Name of Corporates: Benson & Hedghes Microsoft
(b) Incorporated in: Australia USA
(c) Interest rate in:
= AUS 15% 16%
= USA 11% 10%
(d) Fund Requirement: 100 Million USD 500 Million AUD
(e) Exchange Rate: 5 AUD = 1 USD
(f) Swap Bank's Commission: .20% .20%
How the Currency Swap Operates:
(i) By observing above data, it appears that both the companies have 1 % borrowing advantage in their home currency.
(ii) Microsoft will borrow 100 Million USD in USA & Benson & Hedghes 500 AUD in Australia.
(ii) Both the corporations will be entered into swap contract through a swap bank. They will pass on this borrowed amount to each other through swap bank. In exchange of services to be rendered, bank will take part of the savings involved in the swap.
(iv) Above swap arrangement will result in reduction of borrowing cost by 1 %. It is this relative advantage that allows currency swap to materialize.
(v) Interest liability in the respective currency will be passed on to other party through .swap bank in above example, Microsoft will pay (500 × 15.20% in AUD) to swap bank. Swap bank will pay to Benson & Hedghes (500 × 15% in AUD), which B & H will pass on to its lender. Similarly, B&H will pay to swap bank (100 × 10.20% in USD). Swap Bank will pay to MSFT (100 × 10%), which MSFT will pass on to its lender. At the end of the term of the debt, re-exchange of debt will be affected through swap bank.