1. elements of both interest rate and currency

1.      Where did the swap market originate?
Why?

Started from assertions made in Great Britain in the 1970s
to dodge remote trade controls embraced by the British government. The primary
swaps were minor departure from money swaps. The British government had a
strategy of burdening remote trade exchanges that included the British pound.
This made it more troublesome for money to leave the nation, along these lines
expanding household venture.

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2.      
Why are swaps so popular? What is their economic rationale?

Swaps are contractual agreements
to exchange or swap a series of cash flows.

                These
ash follows are most commonly the interest payments associated with debt
service.

•             If
the agreement is so for one party to swap its fixed interest rate payments for
the floating interest rate payments of another, it is termed as interest rate
swap.

•             If
the agreement is to swap currencies of debt service obligation, it is termed a
currency swap.

•             A
single swap may combine elements of both interest rate and currency swap.

Economic rationale of
swap:

When favorable stocks are less likely, the exposed firm
chooses to issue long term debt and uses a floating for fixed interest rate
swap to take advantage of declining interest rates. These results provide an
economic rationale for the widespread use of interest rate swaps by nonfinancial
firms.

3.      How would you define currency swap?

Currency swaps
are a fundamental money related instrument used by banks, multinational
enterprises and institutional financial specialists. A money swap includes two
gatherings that trade a notional primary with each other so as to pick up
introduction to a coveted cash.

If the
assention between two gatherings is to swap monetary forms of obligation
benefit commitment it is additionally named as cash swap.

a)     
Mechanics
of currency swap:

The swap agreement is a contract
in which one party borrows one currency from, and simultaneously lends another
to, the second party. Each party uses the repayment obligation to its
counterparty as collateral and the amount of repayment is fixed at the forward
rate as of the start of the contract.

               

 

 

b)     
Cash
flow diagram:

                                         Principal

Euro debt
market

Dollar debt
market

                                                                                                                                                          
Principal

                                           Euro                                               Euro

Firm A

Swap dealer

Firm B

                                             Dollar                                            Dollar

 

 

c)      
Role
of credit ratings in SWAP

Approaching a credit rating
agency is a good option for small and medium enterprises given the problem they
face in seeking finance. Rating agencies assess a firm’s financial viability
and capability to honor business obligations, provide an insight into sales,
operational and financial composition, thereby assessing the risk element and
highlights the overall health of enterprise, they also benchmark their
operation within the industry as well and also plays a vital role in two
counterparties of SWAP contracts.

4.     
Analyze
a swap between two companies

Company A and B have been offered the following rates per
annum on a 20 million five year loan:

Companies:        Fixed rate           Floating
rate

Company A:       5.0%      LIBOR+0.1%

Company B:        6.4%      LIBOR+0.6%

Company A expects interest rates
to decline and wants floating rate borrowings so company A needs floating rate
borrowing but already have access on fixed interest rate. While company B
expects interest rates to rise and wants to lock in the fixed rate available to
it but have already access on floating interest rate. Design a swap that will
net a bank, acting as intermediary, 0.1% per annum and that will appear equally
attractive to both companies.

 

 

a)     
Comparative
advantage:

One party
trades fixed interest rate payments in exchange for floating interest rate
payments of another party. Each demonstrates a comparative advantage in a
particular credit market. A company with higher credit rating, for instance
pays less to raise funds under identical terms than a less creditworthy
company.

In our above
example A has an apparent comparative
advantage in fixed rate markets but wants to borrow floating. B have an
apparent comparative advantage in
floating rate market but wants to borrow fixed. This provides the basis for the
SWAP.

There is a
1.4% (6.4%-5.0%) per annum differential between the fixed rates offered to the
two companies and 0.5% (LIBOR+0.6%-LIBOR+0.1%) differential between the
floating rates offered to the two companies. The total gain to all parties from
the SWAP is therefore 1.4%-0.5=0.9% per annum because the bank gets 0.1% of
this gain, the SWAP should make each of A and B 0.4% per annum better off. This
means that it should lead to A borrowing at LIBOR -0.3% and to B borrowing 6.0%
the appropriate arrangement is therefore as shown in our figure

                                     

Fixed
rate loan market

Floating
rate loan market

                         5.0%                                                                             LIBOR+0.6%            

5.3%                                      5.4%

Company A

Bank

Company B

                                    LIBOR                                                 LIBOR

Company A

A needs
floating interest rate available for it LIBOR+0.1%

Access to
cheap fixed interest rate 5.0%

Cost = 5.0%

Receive = 5.3%

Difference =
0.3% (5.3%-5.0%)

= 0.3*360/365

= 0.2959%

=
LIBOR+0.1%-0.2959%

=
LIBOR-0.1959%

 

Company B

B needs fixed
interest rate available for it at 6.4%

Access to
cheap floating rate LIBOR+0.6%

Cost = LIBOR+0.6%

Receive =
LIBOR

Difference =
0.6%

= 0.6*365/360

= 0.608%

= 5.4%+0.608%

= 6.008%

= 6.4%-6.008%

= 0.392%

b)     
Absolute
advantage

Absolute
advantage is the ability of an individual or a company to carry out a
particular economic activity more efficiently than another individual or
company.

Now suppose if
we set up the LIBOR at constant for both companies then company A has an
apparent absolute advantage in fixed rate markets.

 

c)      
Gain
from SWAP between parties

Company A = LIBOR-0.1959%

Company B = 0.392%

Bank = 0.1%

5.     
Where
do the gains from SWAPs arise from? Find three reasons?

?A cash SWAP enables the two
counter gatherings to SWAP loan fee on obtaining in various monetary forms.
However picks up from SWAP emerge from following reasons

Flexibility :

Unlike
interest rate SWAP which allows companies to focus on their comparative
advantage in borrowing in single currency in the short end of maturity
spectrum, currency SWAP gives companies extra flexibility to exploit their
comparative advantage in their respective in their respective borrowing
markets.They also provide a chance to exploit advantage across a network of
currencies and maturity.

Exposure :

 

Cash swaps
create a bigger credit introduction than loan fee swaps due to the trade and
re-trade of notional vital sums. Organizations need to think of the assets to
convey the notional toward the finish of the agreement, and are obliged to
trade one cash’s notional against the other at a settled rate.

The more
genuine market rates have veered off from this contracted rate, the more
noteworthy the potential misfortune or pick up.

This potential
introduction is amplified as unpredictability increments with time. The more
drawn out the agreement, the more space for the money to move to the other side
or the other of the settled upon contracted rate of important trade. This
clarifies why money swaps tie up more prominent credit lines than standard loan
fee swaps.

Pricing :

Money swaps
are estimated or esteemed similarly as loan cost swaps utilizing a marked down
money streams investigation having gotten the zero coupon form of the SWAP
bends.

By and large,
a money swap executes at beginning with no net esteem. Over the life of the
instrument, the cash swap can go “in-the-cash,”
“out-of-the-cash” or it can stay “at-the-cash.”

6.      Why investors use fixed and floating rates in
setting up currency SWAP?

Speculators
utilize settled and drifting rate swaps to change over monetary introduction,
to got relative favorable position, to guess on financing costs on monetary
forms.

How about we
assume a hazard searcher speculator anticipate that loan fee will rise and
needs to secure in the settled rate accessible for him/her. So he picks a swap
get that give him settled loan fee.

A hazard
opposed financial specialist anticipates that loan costs will decay and needs
coasting rate obtaining. So he picks a swap that gives him skimming loan fee.

7.      What are the differences and similarities
between FX and interest rate SWAPs?

Differences:

 

ü 
An loan
cost swaps is a monetary subsidiary contract in which two gatherings
consents to trade their financing cost money streams.

ü 
While
Foreign trade (cash swap) is monetary subsidiary contract in which two
gatherings consents to trade of money.

ü 
Interest
rate swaps is a contact or understanding between two gatherings wherein one
arrangement of settled future money streams of premium installments is traded
for another arrangement of gliding future money streams of premium installments
in light of as a rule a same primary sum. The installment isn’t of vital sum
yet of the intrigue sum that is traded with a specific end goal to fence the
danger of fluctuating loan fees or can be portrayed as swapping of fluctuating
financing costs and coasting loan costs.

ü 
Currency
swaps is an agreement or understanding between two gatherings wherein one
gathering trades the key and enthusiasm for one cash with primary and
enthusiasm for another money held by another gathering. They are likewise done
to support danger of changing financing costs and danger of variance in outside
trade rates.

 

ü 
Similarity:

Currency swaps and foreign exchange swaps are
very similar to one another as they aid in hedging foreign exchange risk and
offer corporations a mechanism in which foreign exchange can be obtained with
minimal exposure to exchange rate risk.

 

 

.

8.How many types of swaps?

There are fundamentally four sorts of swap

1   Interest rate swaps

2.  Currency swaps

3.  Cross cash swaps

4.  Credit default swaps

 

Financing
cost swap:

Financing cost swap is a contact or assention
between two gatherings wherein one arrangement of settled future money streams
of premium installments is traded for another arrangement of gliding future
money streams of premium installments in light of for the most part a same main
sum. The installment isn’t of primary sum yet of the intrigue sum that is
traded keeping in mind the end goal to support the danger of fluctuating loan
fees or can be portrayed as swapping of fluctuating financing costs and
drifting financing costs.

Cash swap:

Cash swaps is an agreement or assention between two
gatherings wherein one gathering trades the foremost and enthusiasm for one
money with main and enthusiasm for another money held by another gathering.
They are additionally done to fence danger of changing loan costs and danger of
vacillation in remote trade rates.

Cross money swap:

A traverse the counter subordinate in a type of an
assention between two gatherings to trade intrigue installments and principals
on credits named in two unique monetary forms.

Credit default swap:

A credit default swap is a specific sort of swap
intended to exchange the credit introduction of settled wage items between at
least two gatherings. In a credit default swap the purchaser of the swap
influences installments to the swaps merchant to up until the point that the
development date of agreement consequently the vender concurs that if the
obligation backer default or encounters another credit occasion the dealer will
pay the purchaser the security’s premium and additionally all intrigue installments
that would have been paid between that time and the security’s development
date.

A credit default swap is the most well-known type of
credit subsidiary and may include city securities, developing business
sector securities, contract supported securities or corporate securities.