Currency Swap A currency swap is one in which one party agrees to exchange payments based on one currency with another party based on another currency Party A borrows in one currency, e.g. INR, and party B borrows in another currency, e.g. USD: the loan is swapped so that party A pays the interest in USD, and party B pays the interest in INR In a currency swap, cash flows are exchanged in two different currencies Notional principals are the same based on current exchange rate, which are also exchanged
Currency Risk in Currency Swap As periodic coupon and final exchange of notional principal are in different currencies, currency risk can arise from this If a company has cash inflow in the swap currency, the periodic payments can be paid without converting local currency—currency risk is thus avoided If a company has no cash inflow in the swap currency, currency risk exists
The Uses of a Currency Swap1.To hedge currency risk; and2.To reduce funding costs
Interest Rate Swap A fixed interest rate loan is exchanged for a floating interest rate loan. Party A will borrow in the market at a fixed rate; Party B will borrow in the market at a floating rate; interest payments will be swapped at every reset period of the floating-rate loan. The rate at which party A will pay interest to party B and vice versa are known as swap rates, which are determined in the market. Principal will not be exchanged, and interest amount will be calculated on notional principal.
Uses of the Interest Rate Swap• Hedging interest rate• Reduce funding costs• Manage the duration gap by banks• Speculating on interest rate movements
Interest Rate Swaps: An Example A can borrow at either LIBOR + 70 points, or at a fixed rate of 9% B can borrow at either LIBOR + 20 points, or at a fixed rate of 8.2% Both can have a lower cost of funding if A borrows at LIBOR + 70, and B borrows at a fixed rate of 8.2%, and they swap Swap rates are fixed at 8.2%, and the floating rate at LIBOR + 5 Net cost for A will be 8.85% fixed, and for B will be LIBOR + 5 points Both save an interest rate of 0.15%
Interest Rate Futures in India IRF will expand the scope of the financial markets & exchange traded IRF are more transparent in terms of price discovery ,margining ,risk management & settlement. IRF will enable corporate to hedge interest rate risk. Settlement date is the last day of the month. In India Future Contract available 10-year 7% coupon (compounded semi-annually) GOI bonds.