Finally, at the end of the swap usually also the date of the final interest payment , the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time. Figure 4: Cash flows for a plain vanilla currency swap, Step 3. The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage.
The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits e. This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap pay a fixed rate and receive a floating rate to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing.
For example, consider a well-known U. It will likely receive more favorable financing terms in the U. By using a currency swap, the firm ends up with the euros it needs to fund its expansion. To exit a swap agreement, either buy out the counterparty, enter an offsetting swap, sell the swap to someone else, or use a swaption. Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date.
This is similar to an investor selling exchange-traded futures or options contracts before expiration. There are four basic ways to do this:. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.
Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.
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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. So in each period, regardless of what happens to LIBOR or any other benchmark-- so this is to probably another lender, or different lender, than the person that A borrowed it from. And it could be a bank, or it might be another company, or an investor of some kind. We will call this Lender 1 and Lender 2. Now let's say that neither of these parties are really happy with that situation.
Company A doesn't like the variability, the unpredictability in what happens to LIBOR, so they can't plan for how much they have to pay. Company B feels like they're overpaying for interest. They feel like, wow, the people who are doing variable interest rates, they're paying a less amount of interest every period. And maybe they also, company B also, thinks that interest rates are going to go down, or that short term, or that variable rate is going to go down, LIBOR is going to go down.
So that's an even bigger reason why they want to become a variable rate borrower. The information shared on Instagram. Please note that Instagram. All rights reserved. Log In. Search Search. Search Search Search. Related Articles How interest rate swaps work What financing options are available to small business owners. Related Articles 8 steps to take before buying a dental practice 5 questions to ask before buying new equipment for your practice.
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