A Business Encyclopedia

Risk Hedging with Swaps

Definition: A Swap is a financial agreement wherein the parties agree to trade cash flows over a period of time. It is the portfolio of a forward contract that involves multiple exchanges over a period of time while the forward contract involves a single transaction at a specific future date.

The swaps are the highly liquid financial derivatives and have the following distinct features:

  • It involves the effective translation of fixed rate borrowing to the floating rate borrowing and vice-versa. The difference in the interest amount is either paid or received, as the case may be.
  • It applies to both the new and the existing borrowings.
  • In accounting, it is treated as an off-the-balance-sheet transaction.
  • It is considered as a distinct contract from the underlying loan agreement.
  • There is no exchange of principal repayment obligations.

The Swap contracts are a more flexible financial instrument and can be used in many situations.The two most common forms of swaps are Currency Swaps and Interest Rate Swaps. These two swaps can be combined in case the loan is in two currencies and needs to be swapped.

Currency Swaps: The currency swap includes the exchange of cash payments in one currency for the cash payments in another currency. Simply, in a currency swap contract, the principal, and interest in one currency is exchanged for the principal and interest in another currency. Thus, currency swap includes:

  • Exchange of principal amounts
  • Exchange of interest payments during the term of the loan
  • Re-exchange of the principal amount at the maturity of the loan term.

Often, the international companies find difficult to raise foreign currency to make the investments in abroad and therefore, the currency swaps are used to overcome such problem.

For example, If an Indian company wants to make an investment in the US, but the US government regulations restrict the purchase of US dollars to make the investments. In such situation, the Indian company is allowed to lend rupees and borrow US dollars and to do so, it might find the company in the US that requires Indian rupee to invest in India and would lend rupee to that company and borrow US dollars in return.

Interest Rate Swaps: The interest rate swap contract includes the exchange of one stream of interest obligation for another. Simply, it is the form of transaction that allows the company to borrow capital at a fixed interest rate and exchange its interest payments with interest payment at a floating rate and vice-versa.

For example, A company has a 10 year fixed rate loan of Rs 50 Lacs carrying the interest rate of LIBOR plus 200 basis points. The principal amount is to be repaid at the end of 10 years. The company wants to convert its fixed rate obligation into the variable rate obligation. The company can either borrow a loan of Rs 50 Lacs on a floating rate basis and pay the fixed rate obligations of the earlier loan through its proceeds, but this method is quite expensive. Thus, a less expensive option would be to use the currency swaps, wherein the company can convert its fixed rate obligations to the floating rate obligations.

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