Home Contributors Defining Cross Currency Swaps Interest Rate Swaps

Defining Cross Currency Swaps Interest Rate Swaps

Posted by Simon on Jan 8, 2012

What is a Swap? Exchanging of Financial Instruments based on differences in Interest Rate or Currency Rates for Cross Currency Swaps or Interest Rate Swaps .

Types of Swaps � Cross Currency Swaps and Interest Rate Swaps, Difference between the two.

A swap is a derivative in which counterparties exchange Currency Rate and Interest Rate benefits of one party’s financial instrument for those of the other party’s financial instrument.

In this article, we will highlight Swaps. There are two types of Swaps � Cross Currency Swaps and Interest Rate Swaps. In finance, a swap is a derivative in which counterparties exchange Currency Rate and Interest Rate benefits of one party’s financial instrument for those of the other party’s financial instrument. Swaps benefits in question depend on the type of financial instruments involved.

Example of Interest Rate Swaps and Currency Swaps

For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

Interest Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

Most swaps are traded over-the-counter (OTC), “tailor-made” for the counterparties. Some types of currency swaps or interest swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG.

Types of Swaps � Cross Currency Swaps and Interest Rate Swaps : Interest Rate Swaps

The most common type of swap is a �plain Vanilla� interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the interest swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a Interest rate swap comes in. An interest rate swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

Types of Swaps � Cross Currency Swaps and Interest Rate Swaps : Currency Swaps

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

- Manish Kapoor – EAGLE FINANCIAL SERVICES (www.eaglefinancialservices.co.in)