An Introduction to Swaps A swap is an agreement between counter-parties toexchange cash flows at specified future times accordingto pre-specified conditions. A swap is equivalent to a coupon-bearing asset plus acoupon-bearing liability. The coupons might be fixed orfloating. A swap is equivalent to a portfolio, or strip, of forwardcontracts--each with a different maturity date, and eachwith the same forward price.
currency swapsA currency swap is a foreign-exchangeagreement between two institute to exchangeaspects (namely the principal and/interestpayments) of a loan in one currency forequivalent aspects of an equal in net presentvalue loan in another currency.A currency swap should be distinguished froma central bank liquidity swap.
Example As a example, suppose the British Petroleum Companyplans to issue five-year bonds worth £100 million at7.5% interest, but actually needs an equivalent amountin dollars, $150 million to finance its new refiningfacility in the U.S. Also, suppose that the Piper Shoe Company, a U. S.company, plans to issue $150 million in bonds at 10%,with a maturity of five years, but it really needs £100million to set up its distribution center in London.
ExampleTo meet each others needs, supposethat both companies go to a swapbank that sets up the followingagreements:
ExampleAgreement 1:1. The British Petroleum Company will issue 5-year£100 million bonds paying 7.5% interest. It will thendeliver the £100 million to the swap bank who willpass it on to the U.S. Piper Company to finance theconstruction of its British distribution center.2. The Piper Company will issue 5-year $150 millionbonds. The Piper Company will then pass the $150million to swap bank that will pass it on to the BritishPetroleum Company who will use the funds tofinance the construction of its U.S. refinery.
ExampleAgreement 2:1. The British company, with its U.S. asset will paythe 10% interest on $150 million to the swap bankwho will pass it on to the American company so itcan pay its U.S. bondholders.2. The American company, with its British asset willpay the 7.5% interest on £100 million to the swapbank who will pass it on to the British company soit can pay its British bondholders.8
ExampleAgreement 3:1. At maturity, the British company will pay $150million to the swap bank who will pass it on to theAmerican company so it can pay its U.S.bondholders.2. At maturity, the American company will pay £100million to the swap bank who will pass it on to theBritish company so it can pay its Britishbondholders.9
Uses of CURRENCYSWAPSCurrency swaps have two main uses:To secure cheaper debt (by borrowing at thebest available rate regardless of currencyand then swapping for debt in desiredcurrency using a back-to-back-loan).To hedge against (reduce exposure to)exchange rate fluctuations
HEDGEInstead of forward contracts, the swap bankalso could hedge its swap position by usinga money market position.For example, on its first sterling liability of£500,000 due in one year, the bank wouldneed to create a sterling asset worth£500,000 one year later and a dollarliability worth $764,524 .
Typical Uses of aCurrency SwapTo convert a liability in one currencyinto a liability in another currency.To convert an investment (asset) inone currency to an investment inanother currency.
Credit Risk: CurrencySwapsNote that there is greater credit risk with acurrency swap when there will be a finalexchange of principal.This means that there is a higherprobability of a large buildup in value,giving one of the counter-parties (the onewho is losing) the incentive to default.
Credit RiskNo credit risk exists when a swap is first created.The credit risk in a swap is greater when there isan exchange of principal amounts at termination.Only the winning party (for whom the swap is anasset) faces credit risk. This risk is the risk thatthe counter-party will default.Many vehicles exist to manage credit risk:Collateral or collateral triggersNetting agreementsCredit derivativesMarking to market