Finnovation: Swap Agreements
This financial innovation helps in
hedging various fluctuations like interest rate fluctuations. SWAP is an
agreement between counter-parties to exchange financial instruments for a
certain time.
BY RADHIKA SETHI | 3 Mins Read
What is a swap agreement?
Swap is a derivative contract through which 2 parties exchange the
cash flows or liabilities from two different financial instruments. It involves
cash flows on the basis of a notional principal amount such as a loan or
bond.
Swaps are contracts mainly between businesses or financial
institutions.
It is like a series of forward contracts through which two parties
exchange financial instruments, resulting in a common series of exchange dates
and two streams of instruments, the legs of the swap. The legs
can be anything but usually it involves cash flows based on a notional
principal amount
Mostly, one leg is fixed and the other variable such as benchmark
interest rate, a foreign exchange rate, an index price or a commodity
price.
1. Interest Rate Swaps: They allow two parties to exchange fixed and floating cash flows on an interest-bearing investment or loan. Suppose, a person takes a housing loan in 2000 at 17% interest rate, he can approach a bank now for taking over his old loan for a fresh loan at a lesser rate of interest. The bank will settle his loan with his previous creditor and takes over the security. The borrower is now in the same old position, but his loan with the bank carries a lower rate of interest. This is known as interest swap.
2. Currency swaps: It has efficient ways to hedge foreign risk. By
getting into a currency swap firms are able to obtain low cost loans
and hedge against interest rate fluctuations
3. Commodity Swaps: These are hedging tools against fluctuations
in commodity price or against variation in spreads between the final product
and raw material prices.
4. Zero Coupon Swaps: There is a fixed-fixed coupon swap and a
fixed-floating coupon swap. In a fixed-floating coupon swap, the fixed rate
cash flows are paid at the end of the maturity and not periodically. Under
fixed-fixed one party doesn’t make any interim payments while the other pays as
per schedule. It is beneficial for businesses to hedge a loan in which interest
is paid at maturity or by banks that issue bonds with end-of-maturity interest
payments.
Benefits offered by Swap Agreements:
- Reduction in borrowing cost due to lower interest rates
- Investors can be benefited by switching over their investments to different securities in swap transaction which provide higher return.
- Fluctuations in exchange rates can be smoothened out by swapping currencies
- Capital market helps investors by swapping contracts to minimize their loss.
The concept of FRA (Forward Rate agreement)
It is basically a forward starting loan, but without exchange of
principal. FRAs allows market participants to hedge their interest rate
exposure on future agreements by enabling them to trade at an interest rate
which will be effective in future.