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SWAP
Interest Rate Swap
- With Counter Party – Applying the rule of comparative advantage with counter party
- With Bank – Simple bank arrangement KAPLAN ST
Currency Swap
- Principal & Interest
o Fixed for Fixed
o Fixed for Variable
- Only Interest – Same like IRS above
- Forex SWAP – for long term investment purpose
Interest Rate with counter party
1st Step
More comparative advantage
2nd Step
Payment by stronger party = IR attach with stronger party – sharing of comparative advantage.
3rd Step – SWAP arrangement.

STRONGER PARTY WEAKER PARTY

Actual Borrowing Based on more comparative advantage Against the stronger part (2)
(1)
SWAP
Interest receive Receive (Payment)
stronger party (3)
Interest Payment (Payment based on step 2) Receive
by stronger party
(4)
Bank Charges P.A. (Payment) (Payment)
(5)
E.I.R – With Swap X X
(6)
E.I.R – Without X X
Swap
Comparison (7) X X
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Extract: Lurgshall M/J 2019 (5 Marks)

Advantages of swaps

Transaction costs are generally relatively low. If Lurgshall Co arranged the swap itself, the costs would
be limited to legal fees. The transaction costs may also be lower than the costs of terminating one loan
and arranging another.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever time
period is required, unlike traded derivatives. The period available for the swap may be longer than is
offered for other interest rate derivatives.

Swaps make use of the principle of comparative advantage. Lurgshall Co can borrow in the market
where the best deal is available to it, and then use the swap to access the loan finance it actually wants
at an overall cheaper cost.

Lurgshall Co can, as here, swap a commitment to pay a variable rate of interest which is uncertain with a
guaranteed fixed rate of interest. This allows Lurgshall Co to forecast finance costs on the loan with
certainty.

Disadvantages of swaps

Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on
the arrangement. This would apply in particular if Lurgshall Co arranged the swap itself. If it is arranged
through a bank, the bank can provide a guarantee that the swap will be honoured.

If Lurgshall Co swaps into a fixed rate commitment, it cannot then change that commitment. This means
it cannot take advantage of favourable interest rate changes as it could if it used options. This may be a
particular problem if the swap period is more than a few months and interest rates are expected to be
volatile.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if they are
not needed or become no longer advantageous. It is possible that a bank may allow a reswapping
arrangement to reverse a swap which is not required, but this will incur further costs.
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Currency SWAP = Principal + Interest

Invest in foreign country – finance through borrowing – need to get cheaper rate of interest
Following steps based on the assumption of the arrangement with Fixed for Floating
1st Step:
Total advantage from SWAP:
- Comparative Advantage and sharing (Don’t mix the concept with IR SWAP)
o Comparative Benefit – Fixed Rate X
o Comparative Benefit – Floating Rate X
o Total Benefit X
Allocate with sharing

- Bank Charges and sharing

2nd Step: Effective IR with SWAP
3rd Step: Calculate Net Benefit: A B
EIR – With SWAP X X
EIR – Without SWAP X X
Difference X X
4th Step: SWAP Arrangement

COMPANY A COMPANY B
Actual Borrowing Local Borrowing (Cheaper Rate) Local Borrowing (Cheaper Rate)
SWAP
Interest SWAP (1) (Payment - Only LIBOR) (Receiver – Only LIROR)
Bank Charges (Payment) (Payment)
yearly
Interest SWAP (2) Balancing Figure Balancing Figure

E.I.R – With Swap Amount Calculated at Step 3 Amount Calculated at Step 3

Arrangement with Fixed for Fixed format remain same except the ‘floating term replace with
fixed’
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Currency SWAP (Interest Only) = Same as IR SWAP

Forex SWAP – for long term investment purpose

Parties agree to swap equivalent amounts of currency for a period and then re-swap them at
the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed
between the parties in advance. Thus it is called a ‘fixed rate/fixed rate’ swap.

Objective is to hedge against forex risk, possibly for a longer period than is possible on the
forward market.

Forex swaps are especially useful:

- When dealing with countries that have volatile exchange rates.

- Where it impossible to access to capital markets and borrow directly.
I
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Example = FOREX SWAP

A Dubai based construction company, Hugo, wins a contract to construct a new ‘sub-tropical’ swimming
pool and sports complex in London.

The total cost of constructing the pool has been estimated to be £20 million. Although construction will
take place over a 12 month period, for NPV purposes we can assume that this is all payable immediately.
The local council, who commissioned the complex, has agreed to pay Hugo an amount of £25 million on
completion of the complex in 12 months’ time. This should provide Hugo with a healthy profit margin,
ignoring currency fluctuations, of 20%.

Hugo’s local currency is the dollar. The current spot rate @1,5300 per £1. The 1 year forward rate is
$1,5500 per £1. Hugo’s a two leg plain ‘vanilla’ currency swap on £1. Hugo’s bank has offered Hugo a two
leg plain ‘vanilla currency swap on £20 million and the equivalent in dollars. He swap involves an exchange
of principal only. He first leg of the swap would be at the current spot rate and the second leg would be
at the forward rate.

The treasurer at Hugo has been assessing he risk of exchange rate fluctuations and believes that given
economic conditions, there is a significant chance of the pound falling in value. In the worst case scenario
the pound will weaken to $1,3100 per £1.

Hugo’s cost of capital is 10%.

Requirements

(a) What is the NPV of the investment in dollars if the worst case scenario outlined by Hugo’s treasury
team arises and he investment is not hedged?
(b) What would the NPV be if the investment was edged using the currency swap>
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Currency SWAP: Extract Buryecs M/J 2017

The currency swap will involve Buryecs Co taking out a loan in € and making an arrangement with a
counterparty in Wirtonia, which takes out a loan in $. Buryecs Co will pay the interest on the
counterparty’s loan and vice versa.

Advantages

Payment of interest in $ can be used to match the income Buryecs Co will receive from the rail franchise,
reducing foreign exchange risk.

Buryecs Co will be able to obtain the swap for the amount it requires and may be able to reverse the
swap by exchanging with the other counterparty. Other methods of hedging risk may be less certain.
The cost of a swap may also be cheaper than other methods of hedging, such as options.

The swap can be used to change Buryecs Co’s debt profile if it is weighted towards fixed-rate debt and
its directors want a greater proportion of floating rate debt, to diversify risk and take advantage of
probable lower future interest rates.

Drawbacks

The counterparty may default. This would leave Buryecs Co liable to pay interest on the loan in its
currency. The risk of default can be reduced by obtaining a bank guarantee for the counterparty.

The swap may not be a worthwhile means of hedging currency risk if the exchange rate is
unpredictable. If it is assumed that exchange rates are largely determined by inflation rates, the
predicted inflation rate in Wirtonia is not stable, making it more difficult to predict future exchange
rates confidently. If the movement in the exchange rate is not as expected, it may turn out to have been
better for Buryecs Co not to have hedged.

Buryecs Co is swapping a fixed rate commitment in the Eurozone for a floating rate in Wirtonia. Inflation
is increasing in Wirtonia and there is a risk that interest rates will increase as a result, increasing
Buryecs Co’s finance costs.

The swap does not hedge the whole amount of the receipt in Year 3. Another method will have to be
used to hedge the additional receipt from the government in Year 3 and the receipts in the intervening
years.

If the government decides to impose exchange controls in Wirtonia, Buryecs Co may not be able to
realise the receipt at the end of Year 3, but will still have to fulfil the swap contract.
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PRACTICE QUESTIONS:
1. Buryecs M/J 2017
2. Casasophia Co Part C June 2011 = FOREX SWAP