

Corporate
Finance FIN 622
VU
Lesson
43
FOREIGN
EXCHANGE MARKET'S
SWAPS
We
shall cover following topics
in this hand out:
Calculating
financial benefit Interest rate
Option
Interest
rate caps and
floor
Swaps
Interest
rate swaps
Currency
swaps
Calculating
Financial Benefit Interest
Rate Option
Almost
the calculation involved to reach at the
gain or loss are the same as
we did in equity or stock
options.
As earlier stated that loss
under option is generally limited to the
cost of option paid to the
option
seller.
It is of immense importance to understand the
scenario to perform
calculations.
We
take up borrowing scenario.
The company or the firm intends to
borrow in near future and
anticipates
that
interest rates will be up
when it actually will
utilize the loan amount. If interest
rises then it will be
incurring
more interest cost then
present. Therefore, the firm will
set up or buy the option
against the rise
in
interest rates and the
option will be profitable or
exercisable only if interest
rate does increase.
The
calculations are as under (assuming
that interest rates have
gone up):
Compute the
interest rate using notional
amount @ prevailing interest rate.
This will be the rate at the
time
of
exercising the option, which is
assumed higher than the agreed rate.
(Interest
Expense)
The
second component is the cost of option.
(Cost of
Options)
Third
line item in this calculation will be the
receipt from the option
seller. The notional amount
is
multiplied
with the difference between the
prevailing interest rate and
agreed rate, adjusted for
the period of
loan.
This is income of the option
holder. (Receipt
from Option)
If we
sum
(Interest
Expense) + (Cost of Options)  (Receipt
from Option) = Net
Interest Expense.
The
next step will be to
calculate the effective interest expense,
which can be computed by dividing
Net
Interest
Expense by the
loan amount. This effective interest
rate is less than the rate
prevailing in the
market.
Interest
Rate Caps and Floor
Firms
may borrow from a bank or deposit funds
at variable rate of interest connected to
some benchmark
rate
like KIBOR in Pakistan or
LIBOR (London Inter Bank
Offered Rate) in international
money markets.
When
borrowing on variable interest rates, a
firm may want to utilize
option as hedging tool against
the
unfavorable
interest rate movements over
the full term of loan or
deposit.
Interest
Rate Cap is a
series of borrower option
that sets a maximum interest
rate for a medium term
loan.
The
cap holder has the right to
exercise the option at each
interest fixing date or
rollover date for the
loan.
Whenever
an option is exercised within a
cap agreement, there is cash
payment from the seller of the
cap to
the
cap holder.
Interest
rate floor is an
option to limit interest
rate to a given minimum.
This
is a series of option for
lenders setting minimum
interest rate for medium
term deposits. The
floor
holder
can exercise option at the
dates given in the option.
Interest
rate caps & floor are
like normal options with a difference
that in case the option is
exercised the
cash
settlement is made at the end of
interest period and not in
the beginning. Secondly, more than
one
period
is covered and this may be
two to five years divided
into three or six month
periods. However,
these
are
very expensive options due to
high premium cost.
Swaps
A swap
is a contract between to parties to
exchange their cash flows
related to specific obligations for
an
agreed
period. A swap may be for
interest rate or for
currency.
A
vanilla interest rate swap
is a contract between two
parties to exchange interest
rates on a notional
amount at
regular intervals. One party opts for
interest payments based on the
fixed interest rate and
other
at variable
rate. A swap may have
life up to 30 years. Swaps
are used to hedge interest
rate risk on short
term as
well as longterm instruments
like bonds and
loans.
A firm
can use swaps to manage the
mix of its fixed rate
and floating rate debt
obligations, without having
to
change the underlying loans
themselves. Swap allows the
company to borrow at an effective fix
rate
when
it cannot do directly from the market
due to its size.
143
Corporate
Finance FIN 622
VU
If a
firm anticipates a rise or
fall in the shortterm interest rates
compared to long term interest
rate, it may
utilize
swap to take more floating
rate and less fixed
rate debt obligations or the other
way round.
In short,
swap are used to exchange
floating rate interest
payments to fixed rate
payments and fixed
rate
payment
to floating rate
payments.
Saving
on the interest payment for borrowers
arise because of arbitrage
gains which are normally
related to
differential
risk spreads on the floating and
fixed loan in a single market
where the premiums
associated
with
fixed and floating debt
are likely to differ because
the markets have different
characteristics.
Currency
Swaps
These
are similar to interest rate
swaps but the underlying obligations
are currencies. In currency
swaps, the
currencies
underlying swap are
exchanged at the end of the swap
and may be at the beginning of the
swap.
When
currencies are exchanged at the
beginning and the end, same
exchange rate is used.
Putting in other
words,
amount exchanged at the start and
end of swap is the same.
Interest payments by each party
could
be
fixed or floating.
With
the standpoint of a financial manager or a
treasurer, swap offer
following benefits:
These
provide access to greater
markets where the companies
have no direct approach. Particularly,
large
size
and high rated companies
have access to money market
but swaps provide small
companies to access
this
market.
It
allows company to change an
adverse fixed with favorable
floating and vice
versa.
Flexibility
(not being standardized): swap
can be arranged for any
sum and period.
Comparatively
low cost option
Off
balance sheet transaction
shown as contingencies &
commitments
However,
there are some risks
associated with swaps as
well.
There
may be some probability of
default by either party before the swap
expiry. This can be reduced
by
transacting
with bank or using financial institution
as an intermediary.
There is a
market risk as well. This represents the
increase in the interest rates
unfavorably after the
company
has agreed to swap.
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