Swaps introduction

A swap is a derivative contract
through which two parties exchange financial instruments. These instruments can
be almost anything, but most swaps involve
cash flows based on a notional principal amount that both parties agree to.

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Question
1

Where
did swaps market originate? Why

Swap agreements originated from
agreements created in Great Britain in the 1970s to circumvent foreign exchange
controls adopted by the British government. The first swaps were variations on
currency swaps. The British government had a policy of taxing foreign exchange
transactions that involved the British pound. This made it more difficult for
capital to leave the country, thereby increasing domestic investment.

Swaps
were originally conceived as back-to-back loans. Two companies located in different
countries would mutually swap loans in the currency of their respective
countries. This arrangement allowed each company to have access to the foreign
exchange of the other country and avoid paying any foreign currency taxes.

  Why swaps are so popular? What is their
economisc rationale

Swaps help to limit or manage exposure to
fluctuations in interest rates or to acquire a lower interest rate than a
company would otherwise be able to obtain. Swaps are often
used because a domestic firm can usually receive better rates than a foreign
firm
an economic rationale for
the use of interest rate swaps by such
nonfinancial firms. In a global … We show that when there is
a favorable (unfavorable) exchange rate shock, an
exposed firm chooses short-term (long-term) debt together with
fixed-for-floating (floating-for-fixed) interest rate swaps.
 define currency swaps?

A currency swap, also known as a
cross-currency swap, is an off-balance sheet transaction in which two
parties exchange principal and interest in differentcurrencies. … The
purpose of a currency swap is to hedge exposure to exchange
rate risk or reduce the cost of borrowing a foreign currency

 

 

What are its mechanics?

 

An FX swap agreement is a
contract in which one party borrows one currency from, and simultaneously lends
another to, the second party. Each party uses the repayment obligation to its
counterparty as collateral and the amount of repayment is fixed at the FX
forward rate as of the start of the contract. Thus, FX swaps can be viewed as
FX risk-free collateralised borrowing/lending. The chart below illustrates the
fund flows involved in a euro/US dollar swap as an example. At the start of the
contract, A borrows X·S USD from, and lends X EUR to, B, where S is the FX spot
rate. When the contract expires, A returns X·F USD to B, and B returns X EUR to
A, where F is the FX forward rate as of the start.

FX swaps have been employed
to raise foreign currencies, both for financial institutions and their
customers, including exporters and importers, as well as institutional
investors who wish to hedge their positions. They are also frequently used for
speculative trading, typically by combining two offsetting positions with
different original maturities. FX swaps are most liquid at terms shorter than
one year, but transactions with longer maturities have been increasing in
recent years. For comprehensive data on recent developments in turnover and
outstanding in FX swaps and crosscurrency swaps,

Draw cash flow diagram?

Swap between two companies

a U.S.-based company
needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S.
dollars. These two companies could arrange to swap currencies by establishing
an interest rate, an agreed upon amount and a common maturity date for the exchange.
Currency swap maturities are negotiable for at least 10 years, making them a
very flexible method of foreign exchange.

 

What is
‘Absolute Advantage’

Absolute
advantage is the ability of a country, individual, company or region to produce
a good or service at a lower cost
per unit than the cost at which any other entity produces that same
good or service. Entities with absolute advantages can produce a product or
service using a smaller number of inputs and/or using a more efficient
process than other entities producing the same product or service.

Who hold absolute advantage

Almost
all countries have an absolute advantage for at least one good or service.
Absolute advantage is achieved through low-cost production. For example, China
and other Asian countries are known to have an absolute advantage with
manufactured goods, because they can take advantage of low unit labor costs.
Canada is known to have an absolute advantage in agricultural production,
thanks to its large areas of low-cost undeveloped land.

Defined comparative advantage

Comparative advantage is an economic law
referring to the ability of any given economic actor to produce goods and
services at a lower opportunity
cost than other economic actors. “.

reason of swaps

?  Interest
Rate Risk

                                Interest
rates might move against the swap bank after it has only gotten half of a swap
on the books, or if it has an unhedged position.

?  Basis
Risk

?                                  If the floating
rates of the two counterparties are not pegged to the same index to the same
index

?  Exchange
rate Risk

                                In
the example of a currency swap given earlier, the swap bank would be worse off
if the pound appreciated.

?  Credit
Risk         

                                This
is the major risk faced by a swap dealer—the risk that a counter party will
default on its end of the swap.

 

Floating to Fixed

A
company that does not have access to a fixed-rate loan may borrow at a floating
rate and enter into a swap to achieve a fixed rate. The floating-rate tenor,
reset and payment dates on the loan are mirrored on the swap and netted. The
fixed-rate leg of the swap becomes the company’s borrowing rate.

Float to Float

Companies
sometimes enter into a swap to change the type or tenor of the floating rate
index that they pay; this is known as a basis swap. A company can swap from
three-month LIBOR to six-month LIBOR, for example, either because the rate is
more attractive or it matches other payment flows. A company can also switch to
a different index, such as the federal funds rate, commercial paper or the
Treasury bill rate.

Fixed for Floating

?  Also
known as Plain Vanilla swap

?  Customer
receives cash flows at a fixed rate of interest and simultaneously pays
cash flows at a floating rate of interest or vice versa.

?  The
cash flows are calculated on a Notional Principal amount.

?  The
floating rate of interest isInvestors call the parts of interest swap agreements
“legs.”

?   In a fixed-for-floating swap agreement, one
party agrees to pay the fixed leg of the swap, with the other party agreeing to
pay the floating leg of the swap.

?  The
fixed rate is the interest charged over the life of a loan and does not change.

?  The
floating rate is an interest rate pegged to an international reference rate
index and is subject to change. The most commonly used reference rate is London
Interbank Offered Rate or LIBOR.

?   usually determined by reference to a
transparent benchmark

?  In
this kind of a swap, both the counter-parties exchange interest amounts based
on two different floating reference rates, through the life of the swap.

?  In
a floating-for-floating interest rate swap agreement, both parties agree to pay
a floating rate on their respective legs of the swap.

?  The
floating rates for each leg of the swap generally come from different reference
rate indexes, but can also come from the same index.

?  If
both parties choose the same index, generally they then choose different payment
dates.

?  The
two main indexes investors use in a floating for floating interest rate swap
are the LIBOR and the Tokyo Interbank Offered Rate or TIBOR

 

What is the combination of FX
and interest rate swaps called? How many swap types can you construct by mixing
the basic flavors?

Types of swaps:

The
five nonspecific kinds of swaps, arranged by their quantitative significance,
are: financing cost swaps, cash swaps, credit swaps, ware swaps and value
swaps. There are likewise numerous different sorts of swaps.

The
most well-known kind of swap is a loan fee swap. A few organizations may have
relative favorable position in settled rate markets, while different
organizations have a similar preferred standpoint in coasting rate markets. At
the point when organizations need to acquire, they search for modest getting,
i.e. from the market where they have near favorable position. In any case, this
may prompt an organization getting settled when it needs coasting or obtaining
drifting when it needs settled. This is the place a swap comes in. A swap has
the impact of changing a settled rate advance into a coasting rate credit or
the other way around.

For instance, party B makes intermittent intrigue installments to
party An in view of a variable financing cost of LIBOR +70 premise focuses.
Gathering A consequently makes intermittent intrigue installments in light of a
settled rate of 8.65%. The installments are ascertained over the notional sum.
The top notch is called variable since it is reset toward the start of each
intrigue figuring period to the then current reference rate, for example,
LIBOR. In all actuality, the genuine rate got by An and B is somewhat lower
because of a bank taking a spread.

Currency
swaps:Acurrency swap includes trading key
and settled rate premium installments on an advance in one cash for central and
settled rate premium installments on an equivalent advance in another money.
Much the same as financing cost swaps, the cash swaps are likewise roused by
similar favorable position. Money swaps involve swapping both main and
enthusiasm between the gatherings, with the sources of income one way being in
an unexpected cash in comparison to those the other way. It is likewise an
exceptionally vital uniform example in people and clients.

Commodity swaps:.An item swap
is an assention whereby a drifting (or market or spot) cost is traded at a
settled cost over a predetermined period. Most by far of ware swaps include
unrefined petroleum

Subordinated risk swaps:A subordinated chance swap (SRS), or value chance swap, is
an agreement in which the purchaser (or value holder) pays a premium to the
merchant (or noiseless holder) for the alternative to exchange certain dangers.
These can incorporate any type of value, administration or legitimate danger of
the hidden (for instance an organization). Through execution the value holder
can (for instance) exchange shares, administration obligations or disaster will
be imminent. Consequently, general and exceptional entrepreneurial dangers can
be overseen, allocated or rashly supported. Those instruments are exchanged
over-the-counter (OTC) and there are just a couple of specific financial
specialists around the world.

Swaps are important risk management tools.
How would you see swaps in the following situations (explain)

Swap
is an instrument utilized for the trading of stream of money streams to
diminish hazard.

The
benefits of swaps are as per the following:

1)
Swap is by and large less expensive. There is no forthright premium and it
lessens exchanges costs.

2)
Swap can be utilized to fence hazard, and long day and age support is
conceivable.

3)
It gives adaptable and keeps up enlightening focal points.

4)
It has longer term than prospects or alternatives. Swaps will keep running for
quite a long time, while advances and fates are for the moderately here and
now.

5) Using swaps can give
organizations a superior match between their liabilities and incomes.

The
drawbacks of swaps are:

1)
Early end of swap before development may bring about a breakage cost.

2)
Lack of liquidity.

3) It is liable to default hazard.

(8) Analyze a Swap between two companies

Company A needs fixed rate funds (available at 12.00) access of
cheap floating rate (LIBOR+ 0.3)

Company B needs floating (LIBOR) available access Fixed cheap rate
(10.50)

                                                                                                                                   

 

 

 

                                                10.75                                                   10.65

                                                                    

                                                LIBOR                                                LIBOR

                                                                                    B
pays interest on LIBOR to F.I

                                                                                    LIBOR
= 0.15

 

Cost=       LIBOR+ 0.3                                               Cost
= 10.50

Revenue = LIBOR                                                     Revenue
= 10.65

Difference
= 0.3* 365/360 = 0.3041                          Difference
= 0.15 * 360/365 = 0.1479

   10.75 + 0.3041 = 11.05                                                        LIBOR
0.148

 

Define
absolute advantage. Who holds the absolute advantage and why?

Absolute advantage position is the capacity of a nation,
individual, organization or area to create a decent or administration at a
lower cost for each unit than the cost at which some other element delivers
that same great or administration.

Company B has the absolute advantage because it has the Libor at
cheap level B give LIBOR to A at the lowest rate instead of market rate and
take interest form A at low level instead of Market.

Define the comparative
advantage. Who has the comparative advantage in segments?

The advantages for a member in such an operation may incorporate
acquiring financing at a lower loan cost than accessible in the nearby market,
and securing a foreordained swapping scale for adjusting an obligation
commitment in remote cash.

Company
A has the comparative advantage because A need fixed rate funds which is
available in market at 12.00 but B give it to at 10.50 at the lowest rate. 

x

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