Master the 5 C’s of Credit

While a “C” average may feel middle-of-the-road on an academic scale, nailing the five C’s of credit is the key to getting funding
from banks and other financial institutions.

The five C’s, or characteristics, of credit — character, capacity, capital, conditions and collateral — are a framework used by
many traditional lenders to evaluate potential borrowers.

However, there aren’t any strict guidelines — different lenders may place more value on certain attributes. Online lenders also
use proprietary algorithms to determine a borrower’s creditworthiness by analyzing finances and other data, such as social media
accounts.

The key to small-business success is focusing on things you can control, says Brad Farris, a business advisor with Anchor
Advisors in Chicago. “The five C’s are one of those things that just are — banks believe in them, so we have to deal with it,” he
says.

We’ve rounded up the five characteristics and some tips for putting your best foot forward.

Five C’s of credit

1. Character
2. Capacity/Cashflow
3. Capital
4. Conditions
5. Collateral

1. Character (PEP- Politically Exposed Person), Real-estate, Builders

What it is: A lender’s opinion of a borrower’s general trustworthiness, credibility and personality.
Why it matters: Banks want to lend to people who are responsible and keep commitments.
How it’s assessed: From credentials, references, reputation and interaction with lenders.
How to master it: “Character is something you can control and promote, but only if you have a bank that cares about
relationships,” Farris says. If you have a local or community bank, work to build a relationship. Farris recommends sharing good
news about your business with your banker to help build that relationship and asking if she wants to be added to your company’s
newsletter. “Make yourself someone they want to lend to,” he says.

2. Capacity/Cash flow

What it is: Your ability to repay the loan.

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Why it matters: A business must generate enough cash flow to repay the loan. Loans are a form of debt, and they must be repaid
in full.
How it’s assessed: From financial metrics and benchmarks (debt and liquidity ratios, cash flow statements), credit score,
borrowing and repayment history.
How to master it: Some online lenders may be more open to helping you finance immediate cash flow gaps. If you’re focusing
on local banks, pay down previous debt before you apply. Also, calculate your cash flow to understand your starting point before
heading to the bank.

3. Capital

What it is: The amount of money invested by the business owner or management team.
Why it matters: Banks are more willing to lend to those who have invested some of their own money into the venture. Most
lenders are not willing to take on 100% of the financial risk, so it helps borrowers to have some “skin in the game.”
How it’s assessed: From the amount of money the borrower or management team has invested in the business.
How to master it: Nearly 60% of small-business owners use personal savings to start their business, according to the Small
Business Administration. So put some of your own resources into the mix. There are other ways, however, to acquire startup
funding if you don’t want to take on all the risk yourself.

4. Conditions

What it is: How the business will use the loan and how that could be affected by economic or industry factors.
Why it matters: To ensure that loans are repaid, banks want to lend to businesses operating under favorable conditions. They
want to identify risks and protect themselves accordingly.
How it’s assessed: From a review of the competitive landscape, supplier and customer relationships, and macroeconomic and
industry-specific issues to ensure that risks are identified and mitigated.
How to master it: You can’t control the economy, but you can plan. Although it might seem counterintuitive, apply for a line of
credit when your business is strong. “Banks will always be happiest to loan you money when you don’t need it,” Farris says. If
conditions worsen, they may reduce the credit line or take it away, he adds, but at least you have some cushion for a while if
things go south.

5. Collateral

What it is: Assets that can be pledged as security.

Why it matters: Collateral acts a backup source if the borrower cannot repay a loan.
How it’s assessed: From hard assets such as real estate and equipment; working capital, such as accounts receivable and
inventory; and a borrower’s home that also can be counted as collateral.
How to master it: Picking the right business structure can help protect your personal assets from being used as collateral if
you’re sued or if a lender is trying to collect. Making your company a legal entity will help you mitigate the risk.

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Plus one more

In addition to these 5 C's, there’s one more C that can make a world of difference: communication. Your willingness to
communicate openly with your banker and your other advisors about the opportunities and challenges your business faces is key
to a productive financial partnership.

By considering the loan process from the lender’s perspective and understanding what they’re looking for, you’ll know exactly
what you need to do to increase your chances of being approved for a business loan.

That’s where the 5 Cs of Credit come in.

The 5 Cs of Credit is a system that lenders use to evaluate your business’s creditworthiness and ability to repay a loan. Lenders
look specifically at your business’s character, capacity, capital, collateral, and conditions before making their lending decision.
In this post, we’ll explain everything you need to know about these 5 Cs, including how lenders evaluate each trait and how to
boost your business’s 5 Cs so you can secure a business loan. Read on to learn more.

Table of Contents
 Character
o Why Character Matters
o How Lenders Evaluate Character
o How To Improve Character

 Capacity
o Why Capacity Matters
o How Lenders Evaluate Capacity
o How To Improve Capacity

 Capital

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 o Why Capital Matters
o How Lenders Evaluate Capital
o How To Improve Capital

 Collateral
o Why Collateral Matters
o How Lenders Evaluate Collateral
o How To Improve Small Business Collateral

 Conditions
o Why Conditions Matter
o How Lenders Evaluate Conditions
o How To Improve Conditions

 Sealing The Deal

Character
Character refers to a business’s reputation and trustworthiness. Also sometimes called “credit history,” character often translates
to how faithful you’ve been in paying off past debts on time.

Why Character Matters

For lenders, it all comes down to how the question: “Will I get my money back?” Lenders want to work with responsible,
organized businesses that are likely to make their repayments on time.

How Lenders Evaluate Character

When evaluating character, lenders look at:

 Credit report

 Credit scores

 Personal qualities

 References
To analyze your credit history, lenders will often view your credit report and credit score. Lenders take both your business credit
score and your personal credit score into consideration.

They tend to look at how long you’ve been in business as well. The longer you’ve been in business, the more stable you appear.
For lenders, this again means less risk and increased likelihood that your business will be successful enough to cover loan
repayments.

Sometimes, lenders also take a literal approach to the word “character” and analyze your attributes as a business owner.

They may conduct a personal interview or require references (some even go so far as looking at Yelp reviews of your business).
Many online lenders make phone consultations a part of their application processes so that they can help you with any questions
about the application while also getting a feel for you and your company.

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How To Improve Character
If you’re looking to impress lenders with your personality or improve the character of your business, there are a few ways to do
so. Here are fours tips for boosting character:

1. Raise Your Credit Score

Poor credit can be a deal breaker when it comes to loan approval. Taking the extra time to raise your credit score before applying
for loans can help increase your chances of qualifying for the loan you want.
If you don’t know what your credit score is, then that’s the first place to start. Check out these top free credit score sites to learn
where your credit stands.
2. Understand Your Credit Report
It’s also important to understand your credit report and be prepared to explain anything negative on your report. Some lenders
may view your application more favorably if you are able to help them understand your business’s situation. Make sure to take
action to correct any errors that may be affecting your credit report.
Learn more about how to check your credit report and dispute errors by reading 5 Tips To Improve Your Personal Credit Score.
3. Be Professional
Whether interacting with a banker in person or applying through an online lender, put your best foot forward. Always be
professional and kind. Also show the lender that you are knowledgeable about the loan application process and familiar with how
loans work. This shows that you are responsible and experienced in business as well as being personable.

4. Establish A Relationship With Your Bank

If you are seeking a traditional business loan from a bank, establish a relationship with your banker. If the banker likes you and is
familiar with your business, they may be more willing to vouch for you when it comes to loan approval time.

Capacity
Capacity is your business’s ability to pay back the loan. Also sometimes called “cash flow,” capacity is directly related to how
much cash your business has available for loan use.

Why Capacity Matters

Not only do lenders want to see that you have a history of paying your loans on time, they also need to see that you actually have
the cash to do so. They must look at your financial health to ensure that you can afford a loan in the first place, and then use this
information to see how large of a loan amount they can offer you.

How Lenders Evaluate Capacity

Lenders may use the following tools to determine your business’s capacity to afford a loan:

 Cash flow statements

 Cash flow projections

 Bank statements

 Debt service coverage ratio (DSCR)

 Debt-to-income ratio (DTI)

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Most lenders require you to provide cash flow statements and bank statements when you apply for a loan. They also may require
a cash flow projection to get an idea of what your cash flow will most likely look like in the future.

Some lenders may depend on more concrete measures of financial health, like debt service coverage ratios (DSCR) and debt-to-
income ratios (DTI). The debt service coverage ratio measures the relationship between your business’s debt and income, while
the debt-to-income ratio measures the relationship between your personal debt and income as the business owner.

Both of these ratios are used to determine the health of your business’s cash flow and demonstrate how much extra cash you have
available for a loan. Ideally, lenders look for a DSCR of 1.25 or higher and a DTI ratio of 36% or lower.

How To Improve Capacity

The following are four tips for maximizing your business’s capacity; following these steps will demonstrate that your business
can handle a loan and may also increase the size of the loan that you can realistically afford to make payments on.

1. Pay Down Past Debt

If you have a significant amount of outstanding debt, a serious chunk of change is going to paying those loans off each month —
money that could be used to invest in a new loan instead. Try to pay old debt down or off completely. This will increase the
amount of cash flow available for a new loan. This will also show a lender that you have the means to repay a new loan and that
you have a history of successfully paying off debts.

2. Improve Your DSCR

The higher the debt service coverage ratio, the more cash you have to invest in your business and the more likely you are to be
approved for the loan you want. To improve your DSCR, try:

 Increasing your net operating income

 Decreasing your net operating expenses

 Paying off existing debt

Read Debt Service Coverage Ratio: How To Calculate And Improve Your Business’s DSCR to learn more.
3. Lower Your DTI
While lenders usually place more emphasis on the debt service coverage ratio, your debt-to-income ratio is still important. And, if
you’re self-employed, lenders look solely to your DTI ratio to determine if you can afford a loan.

Since the DTI percentage shows how much of your money is already committed to existing debt, the lower your debt-to-income
ratio, the better. Here are the main ways to lower DTI:

 Increase your monthly income

 Pay off existing debt

Read Debt-To-Income Ratio: How To Calculate And Lower Your DTI to learn more.
4. Use Accounting Software
Not only can using accounting software help you balance the books, it can also help you prepare a strong business loan
application. With the right accounting software you can:

 Generate the cash flow statements and financial statements required by lenders

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 Use financial history to create cash flow projections

 Keep track of operating expenses and income so that you can calculate DSCR and DTI correctly
Using accounting software can also show lenders that you are organized and financially responsible. Some lenders even require
that businesses use accounting software for a certain period of time before being approved. If you want to make preparing your
loan application simpler, understand exactly how much you can afford to borrow, and stay in control of your business overall
finances, accounting software is a must.

Take a look at our top-rated accounting programs and our comprehensive accounting reviews for help finding the perfect
software for your business.

Capital
Capital refers to how much money you (or you and your business partners) have invested in your company.

Why Capital Matters

In lenders’ eyes, the more money you personally have invested in your business, the less likely you are to default on your loans.
Lenders see capital investments as a sign that you take your business seriously, and have something to lose if the business goes
under.

It makes sense — if you have money personally invested in your business, you are much more likely to do everything you can to
make that business succeed — which for lenders, translates into doing everything you can to pay your loans off.

How Lenders Evaluate Capital

When considering capital, lenders want to see:

 How much of the owner’s capital is invested in the business

 How the owner’s capital is invested

Lenders primarily look at the amount of owner’s capital invested in the business. Not only do they evaluate how much money
you have invested in the business, they also check to see where you’ve invested that money. If they see that you’ve made smart
investment decisions in the past, they can take comfort in knowing that you will most likely invest a new loan wisely.

How To Improve Capital

If you’re looking to present strong capital to a lender, here’s what you should do.

1. Increase Owner’s Capital

First off, make sure that you actually have money invested in your business. If you haven’t invested any money into your
business, now may be the time to talk to a financial advisor about the best way to increase your owner’s capital and invest in
business growth.

2. Highlight Investment Successes

Lenders like to know exactly how you plan on using the money they may potentially lend to you. If you’ve made successful
investments in the past, like purchasing additional equipment that increased your sales revenue by 25%, and are planning on
purchasing more equipment with the loan your applying for, be sure to tell your lender! It will demonstrate that you’re

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experienced in business and that you’re likely to increase your cash flow (which a lender hears as “we’re getting our money
back”).
What If You Don’t Have Any Capital Invested In Your Business?
If you don’t have any capital invested in your business and aren’t in a financial place where you can do so, you’ll need to rely
heavily on the other 4 Cs. If your character, capacity, collateral, and conditions are particularly strong, you may be able to offset
the lack of capital.

Since lenders use capital to see that you’re committed to your business, show them your commitment in other ways, maybe by
offering strong collateral or articulating a clear business plan and repayment plan.

Collateral
Collateral is an asset (or assets) that are offered up as insurance against you paying back your loan fully and on time. If you
default on your loan, lenders will seize the collateral in order to make up for their losses.
Why Collateral Matters
Much like owner’s capital, collateral means you have something to lose if you default on your loans. The hope for many lenders
is that the collateral will encourage business owners to work hard to repay their loan.

However, if your business does go under, collateral assures lenders that they won’t lose all of their money if you default on a
loan.

How Lenders Evaluate Collateral

Every lender has different requirements when it comes to collateral.

Some require specific assets to be offered up as collateral. Others require a blanket lien, meaning they have the right to go after
your assets in case of a default. Others still require a personal guarantee, meaning you the business owner will be held
responsible in the event of a default.
Some examples of collateral include:

 Property

 Vehicles

 Equipment

 Savings accounts
It’s important to carefully evaluate each lender’s policy and requirements regarding collateral. This way, you can know exactly
what is expected of you. And, more importantly, you can decide if you’re comfortable with the required collateral or if you’d
rather look for a different lender.

To learn more about collateral, read Secured Vs. Unsecured Business Loans.
How To Improve Small Business Collateral
Each lender has their own way of evaluating collateral, so there’s no one right way to improve your business’s collateral.
However, by carefully researching potential lenders, you can work to present strong collateral that meets their standards. Here are
a few tips to consider:

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1. Know What Collateral You Have To Offer
Carefully evaluate your assets and their value so that you know exactly what your business can offer up as collateral. Many
accounting software programs help you track your assets and their depreciation so you can know how much they are worth.

2. Decide What You’re Comfortable With

As we mentioned earlier, some lenders require a blanket lien or a personal guarantee to secure a loan. Neither of these agreements
should be taken lightly and these arrangements are not right for every business.

Read our posts What Is A UCC Blanket Lien? and Should I Sign A Personal Guarantee? to decide if these forms of collateral
are right for you.
3. Find The Right Lender
Required collateral varies from lender to lender. If you aren’t comfortable with something like a personal guarantee or don’t have
much collateral to offer up, do some shopping around until you find a lender that is suited for your business.

Conditions
Conditions are considered in two parts: the conditions of the loan and the conditions of the economy.

Why Conditions Matter

Conditions such as interest rate and principal play an important factor in whether or not you can afford a loan and how big that
loan can be. Factors such as the economy and your business’s market can also play a role in how likely your business is to
succeed and be able to repay a loan.

How Lenders Evaluate Conditions

When considering if the conditions are right to approve your loan, lenders consider:

 Interest rate

 Principal

 Economy

 Your business’s industry

 Your business’s competitors

The actual loan amount you are requesting is very important, but lenders will consider the principle, interest rate, and monthly
payments to determine if you can feasibly take on that loan.
Lenders also carefully consider how you are planning on using the loan as the purpose of the loan can greatly affect whether your
business will grow and profit from the investment.

The economy is also a huge consideration. If the economy is booming, businesses are more likely to flourish, meaning less risk
for lenders. If the economy is taking a downturn, lenders may be more reluctant to lend money. When the economy is poor,
lenders typically increase their minimum DSCR which means businesses have to have an incredibly strong cash flow in order to
be approved.

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Some lenders may look at your specific market and competitors to get an idea of how financially promising your business is.
Certain lenders also have prohibited industry lists, meaning that they will not lend to business in specific high-risk industries. So
before you apply, be sure that your business does not fall into that category.

How To Improve Conditions

You may not be able to control the economy, but you can control how strong your business and its loan application appears. Here
are a few tips on how to put your best foot forward where conditions are concerned.

1. Have A Plan
Don’t just say you need $30,000 for your business. Lenders want to hear exactly what you’re planning on doing with the loan and
how you plan on doing it.

Common reasons for requesting a business loan include:

 Purchasing inventory

 Purchasing property

 Updating equipment

 Hiring new employees

 Expanding your business

 Increasing cash flow

Let your lender know exactly how you’re planning on using the money with a detailed business plan. Increase their faith in your
business by showing how the loan will benefit your business, whether by increasing production, doubling sales, expanding your
business’s services, etc. The more specific you can be the better.

2. Time It Right
Often, small businesses seek a loan when they are in need of money. Makes sense, right? Wrong. Consider applying for a line of
credit when the economy is good and your business is booming. You will be much more likely to qualify for a line of credit with
favorable terms when things are going well. This way, you’ll have cash when you do need it.

If you wait until the economy is poor and your cash flow is stagnant you will be much less likely to be approved for a loan. And
if you are approved, the loan rates may be steep and unfavorable.
3. Show Your Expertise
Be knowledgeable about your business and its market. You can’t control the economy, but you can control how you present your
situation to a lender. If the economy is poor or your business’s market is stalling, show lenders how the loan you’re requesting
will allow you to launch a promising new marketing campaign or expand into a new, profitable business vertical.

Demonstrating your expertise will build their faith and trust in you and your business.

4. Improve Your DSCR

If the economy is poor, another way to increase the likelihood of being approved for a loan is to increase your debt service
coverage ratio. As we mentioned earlier, there are several ways to improve your DSCR, including:

 Increasing your net operating income

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  Decreasing your net operating expenses

 Paying off existing debt

Read our post the Debt Service Coverage Ratio: How To Calculate And Improve Your Business’s DSCR to learn more.
Sealing The Deal

When it comes to loan applications, you don’t want to go in blind. Knowing what lenders are looking for and how they’re
evaluating your application can be the key to securing the loan you need.

When it all boils down, lenders simply want to be certain that you will pay back your loan. The 5 Cs of Credit are how lenders
can realistically evaluate how big of a risk you are.

It’s important to note that not all lenders evaluate each C the same way. Some place more emphasis on character, while others
care more about your capital. Carefully researching each lender’s requirements and following our tips to master each of the 5 Cs
of Credit can greatly increase your chances of sealing the deal on a loan.

In the end, it all comes down to establishing yourself as a trustworthy, credible borrower who can set lenders’ minds at ease. Start
mastering character, capacity, capital, collateral, and conditions to impress lenders and secure the loan you want.

How can derivatives be used for risk management?

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BY STEVEN NICKOLAS

Updated Aug 29, 2018

Derivatives can be used in risk management to hedge a position, protecting against the risk of an adverse move in an asset.

A financial instrument whose price depends on the underlying asset, a derivative is a contractual agreement between two parties
in which one party is obligated to buy or sell the underlying security and the other has the right to buy or sell the underlying
security. Hedging is the act of taking an offsetting position in a related security, which helps to mitigate against opposite price
movements.

For example, assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2015, for $65 a share. He held onto his
investment for over two years and is now afraid that Tesla will be unable to meet its earnings per share
(EPS) and revenue expectations.

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Tesla's stock price opens at a price of $243.93 on May 15, 2018. The investor wants to lock in at least $165 of profits per share
on his investment. To hedge his position against the risk of any adverse price fluctuations the company may have, the investor
buys 10 put option contracts on Tesla with a strike price of $230 and an expiration date on Sept. 7, 2018.

The put option contracts, which are a type of derivative, give the investor the right to sell his shares of Tesla for $230 a share.
Since one stock option contract leverages 100 shares of the underlying stock, the investor could sell 1,000 (100 x 10) shares with
10 put options.

Tesla is expected to report its earnings on Sept. 5, 2018. If Tesla misses its earnings expectations and its stock price falls below
$230, the investor has locked in a sell price of $230 with his put options. So he could sell 1,000 shares, gaining a profit of $165
($230 - $65) per share.

Interest Rate Swap

What it is:

An interest rate swap is a contractual agreement between two parties to exchange interest payments.

How it works (Example):

The most common type of interest rate swap is one in which Party A agrees to make payments to Party B based on a fixed
interest rate, and Party B agrees to make payments to Party A based on a floating interest rate. The floating rate is tied to
a reference rate (in almost all cases, the London Interbank Offered Rate, or LIBOR).

For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up
and down, the payment Charlie receives changes.

Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never
changes.

Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on
receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000 principal amount (called
the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.

Let's see what this deal looks like under different scenarios.

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Scenario A: LIBOR = 0.25%

Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly
payment of $15,000 from her investment ($1,000,000 x 1.5%).

Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him
$15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500.

Scenario B: LIBOR = 1.0%

Now, with LIBOR at 1%, Charlie receives a monthly payment of $20,000 from his investment ($1,00,000 x (1% + 1%)). Sandy
still receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%).

With LIBOR at 1%, Charlie is obligated under the terms of the swap to pay Sandy $20,000 ($1,000,000 x LIBOR+1%), and
Sandy still has to pay Charlie $15,000. The two transactions partially offset each other and now Charlie owes Sandy the
difference between swap interest payments: $5,000.

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Note that the interest rate swap has allowed Charlie to guarantee himself a $15,000 payout; if LIBOR is low, Sandy will owe him
under the swap, but if LIBOR is higher, he will owe Sandy money. Either way, he has locked in a 1.5% monthly return on his
investment.

Sandy has exposed herself to variation in her monthly returns. Under Scenario A, she made 1.25% after paying Charlie $2,500,
but under Scenario B she made 2% after Charlie paid her an additional $5,000. Charlie was able to transfer the risk of interest
rate fluctuations to Sandy, who agreed to assume that risk for the potential for higher returns.

One more thing to note is that in an interest rate swap, the parties never exchange the principal amounts. On the payment date, it
is only the difference between the fixed and variable interest amounts that is paid; there is no exchange of the full interest
amounts.

Why it Matters:

Interest rate swaps provide a way for businesses to hedge their exposure to changes in interest rates. If a company believes long-
term interest rates are likely to rise, it can hedge its exposure to interest rate changes by exchanging its floating rate payments for
fixed rate payments.

Swap

Share3

What it is:

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A swap is an agreement between two parties to exchange a series of future cash flows.

How it works (Example):

Swaps are financial agreements to exchange cash flows. Swaps can be based on interest rates, stock indices,
foreign currency exchange rates and even commodities prices.

Let's walk through an example of a plain vanilla swap, which is simply an interest rate swap in which one party pays a fixed
interest rate and the other pays a floating interest rate.

The party paying the floating rate "leg" of the swap believes that interest rates will go down. If they do, the party's interest
payments will go down as well.

The party paying the fixed rate "leg" of the swap doesn't want to take the chance that rates will increase, so they lock in their
interest payments with a fixed rate.

Company XYZ issues $10 million in 15-year corporate bonds with a variable interest rate of LIBOR + 150 basis points. LIBOR
is currently 3%, so Company XYZ pays bondholders 4.5%.

After selling the bonds, an analyst at Company XYZ decides there's reason to believe LIBOR will increase in the near term.
Company XYZ doesn't want to be exposed to an increase in LIBOR, so it enters into a swap agreement with Investor ABC.

Company XYZ agrees to pay Investor ABC 4.58% on $10,000,000 each year for 15 years. Investor ABC agrees to pay Company
XYZ LIBOR + 1.5% on $10,000,000 per year for 15 years. Note that the floating rate payments that XYZ receives from ABC
will always match the payments they need to make to their bondholders.

Investor ABC thinks that interest rates are going to go down. He is willing to accept fixed rates from Company XYZ

To do this, Company XYZ structures a swap of the future interest payments with an investor willing to buy the stream of interest
payments at this variable rate and pay a fixed amount for each period. At the time of the swap, the amount to be paid over the
life of the debt is the same.

The investor is betting that the variable interest rate will go down, lowering his or her interest cost, but the interest payments from
Company XYZ will be the same, allowing a gain (i.e. arbitrage) on the difference.

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Why it Matters:

Interest rate swaps have been one of the most successful derivatives ever introduced. They are widely used by corporations,
financial institutions and governments.

According to the Bank for International Settlements (BIS), the notional principal of over-the-counter derivatives market was an
astounding $615 trillion in the second half of 2009. Of that amount, swaps represented over $349 trillion of the total.

How do currency swaps work?

A currency swap, also known as a cross-currency swap, is an off-balance sheettransaction in which two parties exchange
principal and interest in different currencies. The parties involved in currency swaps are generally financial institutions that either
act on their own or as an agent for a non-financial corporation. The purpose of a currency swap is to hedge exposure to exchange
rate risk or reduce the cost of borrowing a foreign currency.

A currency swap is similar to an interest rate swap, except that in a currency swap, there is often an exchange of principal, while
in an interest rate swap, the principal does not change hands.

In currency swap, on the trade date, the counter parties exchange notionalamounts in the two currencies. For example, one party
receives $10 million British pounds (GBP), while the other receives $14 million U.S. dollars (USD). This implies a
GBP/USD exchange rate of 1.4. At the end of the agreement, they will swap again using the same exchange rate, closing out the
deal.

Since swaps can last for a long time, depending on the individual agreement, the exchange rate in the market place (not on the
swap) can change dramatically over time. This is one of the reasons institutions use these currency swaps. They know exactly
how much money they will receive and have to pay back in the future.

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During the term of the agreement, each party pays interest periodically, in the same currency as the principal received, to the
other party. There are number of ways interest can paid. It can paid at a fixed rate, floating rate, or one party may pay a floating
while the other pays a fixed, or they could both pay floating or fixed rates.

On the maturity date, the parties exchange the initial principal amounts, reversing the initial exchange at the same exchange rate.

Examples of Currency Swaps

Company A wants to transform $100 million USD floating rate debt into a fixed rate GBP loan. On trade date, Company A
exchanges $100 million USD with Company B in return for 74 million pounds. This is an exchange rate of 0.74 USD/GBP
(equivalent to 1.35 GBP/USD).

During the life of the transaction, Company A pays a fixed rate in GBP to Company B in return for USD six-month LIBOR.

The USD interest is calculated on $100 million USD, while the GBP interest payments are computed on the 74 million pound
amount.

At maturity, the notional dollar amounts are exchanged again. Company A receives their original $100 million USD and
Company B receives 74 million pounds.

Company A and B might engage in such a deal for a number of reasons. One possible reason is the company with US cash needs
British pounds to fund a new operation in Britain, and the British company needs funds for an operation in the US. The two firms
seek each other and come to an agreement where they both get the cash they want without having to go to a bank to get loan,
which would increase their debt load. As mentioned, currency swaps don't need to appear on a company's balance sheet, where as
taking a loan would.

Having the exchange rate locked in lets both parties know what they will receive and what they will pay back at the end of the
agreement. While both parties agree to this, one may end up better off. Assume in the scenario above that shortly after the
agreement the the USD starts to fall to a rate of 0.65 USD/GBP. In this case, Company B be would have been able to
receive $100 million USD for only $65 million GBP had they waited a bit longer on making an agreement, but instead they
locked in at $74 million GBP.

While the notional amounts are locked in are and not subject to exchange rate risk, the parties are still subject to opportunity
costs/gains in that ever changing exchange rates (or interest rates, in the case of a floating rate) could mean one party is paying or
more less than they need to based on current market rates.

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