Table of Contents Economic Justification of SwapHow Would You Define Currency Swap?Mechanics of Currency SwapRole of Credit Ratings in SWAPAnalyzing a Swap Between Two CompaniesGaining SWAP Between PartiesFlexibilityExposurePriceWhy Investors use fixed and floating rates in the definition up exchange SWAP? What are the differences and similarities between foreign exchange and interest rate SWAP? How many types of swaps? A swap is an agreement between two counterparties to exchange two flows cash flow parties cash flow The purpose of the swap is to change the character of an asset or liability without liquidation. The swap issuer may agree to pay a variable rate and receive a fixed rate, or vice versa. Swap contracts as we know them today are a fairly recent phenomenon. The swaps market originated from a swap agreement negotiated in Britain in the 1970s to circumvent exchange controls adopted by the British government. The first swaps were variations of currency swaps. The British government had a policy of taxing foreign exchange transactions involving the pound sterling. This made it more difficult for capital to leave the country, thereby increasing domestic investment. Say no to plagiarism. Get a tailor-made essay on “Why Violent Video Games Should Not Be Banned”?Get the original essayAfter that, in 1981, a major swap deal concluded by Salomon Brothers on behalf of the World Bank and IBM provided for a exchange of cash flows denominated in Switzerland. francs and deutschmarks added luster to the swap market. Why are swaps so popular? What is their economic justification? Swaps are contractual agreements to exchange or exchange a series of cash flows. These ashes are most often the interest payments associated with debt service. If the agreement provides for one party to exchange its fixed interest rate payments for the variable interest rate payments of another, it is called an interest rate swap. If the agreement is To exchange the currencies of the debt service obligation, it is called a currency swap. A single swap can combine interest rate and currency swap elements. Economic Rationale for the Swap When favorable inventory is less likely, the exposed firm chooses to issue long-term debt and uses a floating-for-fixed interest rate swap to take advantage of falling interest rates. These results provide an economic rationale for the widespread use of interest rate swaps by non-financial firms. How would you define currency swap? A currency swap should be distinguished from a central bank liquidity swap. A currency swap is a foreign exchange agreement between two institutions to exchange aspects of a loan in one currency for equivalent aspects of a loan equal in net present value in another currency. Mechanisms of Currency Swap The swap agreement is a contract in which one party borrows one currency from the second party and simultaneously lends another currency to the second party. Each party uses the repayment obligation to its counterparty as collateral and the repayment amount is fixed at the forward rate in effect at the start of the contract. Role of credit ratings in SWAP Going to a credit rating agency is a good option for small and medium-sized businesses given the problem they face in seeking financing. Rating agencies assess the financial viability of a company and its ability to meet its business obligations, provide insight into sales, operational and financial composition, assessingthus the element of risk and highlight the overall health of the business. They also evaluate their operations within the sector. plays a key role in two counterparties to SWAP contracts. Analyzing a swap between two companies Interest rate swaps can hedge companies against interest rate exposure. If a company makes variable interest rate payments on its liabilities, it can enter into a swap agreement with another company or financial institution to hedge against the risk of interest rate fluctuations. In this scenario, the company must create a swap whereby it will make payments at a fixed interest rate to its counterparty, while in exchange it will receive payments at a variable interest rate. This can help companies leverage their comparative advantage to obtain liability. By using swaps, companies can leverage their comparative advantage in short- or long-term borrowing and save money on interest payments. Imagine companies A and B. Company A is an AAA-rated company and it can get a long-term loan with 5% interest and a short-term loan with LIBOR + 0.5% interest. Company B is a BBB rate company and can lend long term with 8% interest and lend short term with LIBOR + 1%. Obviously, Company A has an absolute advantage in obtaining loans over Company B because in both cases they can obtain a loan and pay lower interest rates. However, after calculating quality spreads, we can tell which companies demonstrate a comparative advantage; thus, Company A should borrow long term, while Company B should borrow short term. Therefore, if Company A needs a short-term loan and Company B needs a long-term loan, they can get loans in which they benefit from a comparative rate. advantage and create an exchange between them. The design of the swap may look like this: Gain from the SWAP between the parties. Instead of paying LIBOR + 1% for the short-term loan, Company A will pay LIBOR - 1%, while Company B will pay an interest rate of 7% on its long-term loan. -term loan, instead of 8%. Where do SWAP earnings come from? Find three reasons? A currency SWAP allows the two counterparties to exchange interest rates on borrowings in different currencies. However, the gains from SWAP arise from the following reasons: Flexibility Unlike interest rate SWAP which allows companies to focus on their comparative advantage by borrowing in the single currency on the short end of the maturity spectrum, currency SWAP gives companies with additional flexibility to exploit their comparative advantage in their respective borrowing markets. They also offer the ability to leverage advantage across a network of currencies and maturities. The success of the currency swap market and that of the Eurobond market are explicitly linked. Exposure Currency swaps generate greater credit risk than interest rate swaps due to the exchange and re-exchange of notional principal amounts. Companies must find the funds to deliver the notional at the end of the contract and are obliged to exchange the notional of one currency for the other at a fixed rate. The more actual market rates deviate from this contracted rate, the greater the potential loss or gain. This potential exposure is amplified as volatility increases over time. The longer the contract, the more room the currency has to move to one side or the other of the agreed main exchange rate. This explains why currency swaps mobilize lines ofcredit than traditional interest rate swaps. Pricing Currency swaps are priced or valued in the same manner as interest rate swaps using discounted cash flow analysis having obtained the zero coupon version of the SWAP curves. Typically, a currency swap is traded upon inception with no net worth. Over the life of the instrument, the currency swap may move “in-the-money,” “out-of-the-money,” or remain “in-the-money.” Why do investors use fixed and floating rates to set up exchange SWAP? Investors use fixed and floating rate swaps to convert financial exposure, gain comparative advantage, to speculate on interest rates on currencies. Suppose a risk-seeking investor expects the interest rate to rise and wants to lock in the fixed rate available to him. He therefore chooses a swap contract which provides him with a fixed interest rate. A risk-averse investor expects interest rates to fall and wants to borrow at a variable rate. He therefore chooses a swap which offers him a variable interest rate. What are the differences and similarities between foreign exchange SWAP and interest rate SWAP?Interest rate swap The most common type of swapInterest rate swap is a swap in which party A agrees to make payments to Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on a variable interest rate. And currency swaps are similar to an interest rate swap, except that in a currency swap there is an exchange of principal, while in an interest rate swap the principal does not change hands . Instead, on the transaction date, the counterparties exchange notional amounts in the two currencies. It is a contract or agreement between two parties in which one party exchanges principal and interest in one currency with principal and interest in another currency held by another party. They also aim to hedge the risk of interest rate variations and the risk of exchange rate fluctuations. The basic interest rate swap is a fixed rate for floating rate swap in which one counterparty exchanges the interest payments of a fixed rate debt security for the variable interest payments of the other counterparty. Both debt securities are denominated in the same currency. In a currency swap, one counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty that are denominated in another currency. A swap bank is a generic term to describe a financial institution that facilitates swapping between counterparties. The swap bank serves as either a broker or a dealer. When acting as a broker, the swap bank connects counterparties but does not assume any risk associated with the swap. When acting as a broker, the swap bank is willing to accept either side of a currency swap. In an example of a base interest rate swap, it was noted that a necessary condition for a swap to be feasible was the existence of a quality spread between the default risk premiums on interest rates. fixed rate and variable rate interest from both counterparties. Additionally, it was noted that there was no exchange of principal between the counterparties to an interest rate swap because both debt issues were denominated in the same currency. Interest rate swaps were based on a notional principal. After its creation, the value of an interest rate swap in favor of a counterparty must be the difference between the current values ​​of the payment flows that the..