# Corporate Finance

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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 long-term 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.
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Corporate Finance ­FIN 622
VU
If a firm anticipates a rise or fall in the short-term 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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