Swaps Market

Swaps are private agreements between two companies to exchange cash flows in the future according to a prearranged formula. In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.

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. Thus, an interest rate swap is an arrangement whereby one party exchanges one set of interest payments for another. In the most common arrangement, fixed rate interest payments are exchanged for floating interest payments over time.

In this, one party, B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. At the same time, A agrees to pay B cash flows equal to interest at a floating rate on the same notional principal for the same period of time.

The reason most commonly put forward concerns comparative advantages.
Example: Company A and B, both wish to borrow USD10 million for 5 years. A has a company rating better than that of B. B would like to have the loan on the fixed rate, while A on the floating rate. See the table of borrowing rates motivating interest rate swap.

Fixed Floating
A 10.00% 6-month LIBOR + 0.30%
B 11.20% 6-month LIBOR + 1.00%

LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market.

The difference between the two fixed rates is greater than the difference between the two floating rates. B pays 1.20% more than A in fixed rate markets, and only 0.70% more than A in floating rate markets.

B appears to have a comparative advantage in floating rate markets, while A appears to have comparative advantage in fixed rate markets.

It is this apparent anomaly that allows a profitable swap to be negotiated. A borrows fixed rate funds at 10.00% p.a., while B borrows floating rate funds at LIBOR + 1.00% p.a.
We assume that A and B get in touch with each other directly (no intermediary).

Assume the negotiation result is that A agrees to pay B interest at 6-month LIBOR on USD10 million, and B agrees to pay A interest at a fixed rate of 9.95% p.a. on USD10 million.
When the external borrowings of A and B are taken into account, we obtain the following scheme:

Lenders <-(10%)- Company A <-(9.95%)- -(LIBOR)-> Company B -(LIBOR + 1%)-> Lenders

A has three sets of interest rate cash flows:

• It pays 10% p.a. to outside lenders


• It receives 9.95% p.a. from B


• It pays LIBOR to B

Total cost to A will be LIBOR + 0.05% (10 – 9.95) p.a., instead of LIBOR + 0.30%.

B also has three sets of interest rate cash flows:

• It pays LIBOR + 1.00% p.a. to outside lenders


• It receives LIBOR from A


• It pays 9.95% p.a. to A

Total cost to B will be 10.95% p.a. (9.95 + 1), instead of 11.20%.

The swap arrangement improves the position of both A and B by 0.25% p.a.. The total gain is therefore 0.50% p.a., which is derived from a – b, where:

a is the difference between the interest rates facing the two companies in fixed rate markets; a = 1.2%.
b is the difference between the interest rates facing the two companies in floating rate markets; b = 0.70%.

Role of Financial Intermediary
Usually, A and B do not get in touch with each other directly to arrange a swap. They each deal with a financial intermediary such as bank. The total potential gain (0.5% p.a.) has to be split three ways between A, B and the financial intermediary.

Lenders <-(10%)- Company A <-(9.9%)- -(LIBOR)-> Financial Institution <-(10%)- -(LIBOR)-> Company B -(LIBOR+1%)-> Lenders

A has three sets of interest rate cash flows:

• It pays 10% p.a. to outside lenders


• It receives 9.90% p.a. from the financial institution


• It pays LIBOR to financial institution

Total cost to A will be LIBOR + 0.10% (10 – 9.90) p.a. instead of LIBOR + 0.30%.

B also has three sets of interest rate cash flows:

• It pays LIBOR + 1.00% p.a. to outside lenders


• It receives LIBOR from the financial institution


• It pays 10 % p.a. to the financial institution

Total cost to B will be 11.00% p.a. (10.00 + 1) instead of 11.20%.

The swap arrangement improves the position of both A and B by 0.20% p.a.. The financial institution’s net gain is 0.10% p.a. The floating rate it receives is the same as the floating rate it pays, but the fixed rate it receives is 0.10 % higher than the fixed rate it pays. The total gain to all parties is as before 0.50% p.a.
The financial institution has two separate contracts, one with A and the other with B. If one of the companies defaults, the financial institution still has to honor its agreement with the other company. In most instance, A will not even know that the financial institution has entered into an offsetting swap with B and vice versa.

Currency Swaps
In its simplest form, this involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an approximately equivalent loan in another currency.
Example: Suppose that company A and B are offered the fixed rates of interest in US dollars and sterling. See the table of borrowing rates motivating currency swap.

US Dollars Sterling
A 8.00% 11.60%
B 10.00% 12.00%

A is clearly more creditworthy than B since A is offered a more favorable rate of interest in both currency.
The difference between the rates offered to A and B in the two markets are not the same. B pays 2% more than A in the US dollar market and only 0.4% more than A in the sterling market.
A has a comparative advantage in the US dollar market, while B has a comparative advantage in the sterling market.
Suppose A wants to borrow sterling while B wants to borrow dollars.

Total gain to all parties will be 1.6% p.a. (2.0% - 0.4%), which is the difference between the difference in dollars and sterling.

Lenders <-($ 8%)- Company A <-($ 8%)- -(£ 11%)-> Financial Institution <-($ 9.4%)- -(£ 12%)-> Company B -(£ 12%)-> Lenders

Total cost to A will be 11.6% Sterling, instead of 11.6% Sterling (gain 0.6% p.a.). Total cost to B will be 9.4% Dollar, instead of 10% Dollar (gain 0.6% p.a.). The financial institution will gain 1.4% Dollars and lose 1% Sterling, net gain 0.4% (ignore exchange rate risks).
Total gain to all parties is 1.6% p.a., that is the gap between the difference in dollar and sterling interest rates.

Risks of Swaps

• Basis Risk: risk that the index used for an interest rate swap does not move perfectly in tandem with the floating rate instrument specified in a swap arrangement.


• Credit Risks: risk happens when one party of the swap arrangement fail to meet its payment obligation.


• Sovereign Risks: reflects potential adverse effects resulting from a country’s political conditions. Various political conditions could prevent the counterparty from meeting its obligation in the swap agreement.