Explore BrainMass

Explore BrainMass

    Swaps

    Swaps are a type of derivative that allow parties to exchange the cash flows from one party's financial instrument for the cash flows of the other party's financial instrument - in a way that benefits both parties in the transaction. These two parties are called counterparties, and the streams of cash flows they exchange are called the legs of the swap. Typically a financial institution will act as an intermediary for the parties engaged in the swap, taking a spread from the payments between the two parties. 

    Interest Rate Swaps

    Interest rate swaps allow the two counterparties to exchange interest-rate payments with each other. Typically, interest rate swaps are called vanilla swaps, and they allow one counterparty to exchange a fixed interest-rate payment for a floating interest-rate payment. The notional amount refers to the value of the loan that is subject to the swap. Unlike forwards, futures or options, a vanilla swap will not require parties to exchange the notional amount. 

    In fact, interest rate swaps are by far the world's most popular derivative, with a notional amount related to interest rate swaps of around $300 trillion dollars (several times the world's GDP). Interest rate swaps are used to hedge against fluctuations in interest rates. For example, a firm that has cash flows that vary with interest rates may prefer floating interest payments, and a firm with fixed cash flows may prefer fixed payments. Interest rate swaps are also used by speculators who believe the market is going to go one way of the other. 
     

    In our example, party A must pay a floating rate of LIBOR + 1.50% and party B must pay a fixed rate of 8.50%. If party B wants to pay a floating rate, it will enter into an agreement with the bank to pay the bank LIBOR + 0.70% in exchange for fixed payments on its loan of 8.50%. If party A wants to pay a fixed rate, it will pay the bank 8.65% in exchange for floating payments of LIBOR + 0.55%. The bank profits by taking a spread (the difference between LIBOR + 0.55% and LIBOR + 0.70%, as well as the difference between 8.50% and 8.65%). 

    Currency Swaps

    Currency swaps occur when two parties swap interest rate payments and/or principle payments for the equivalent payments in another currency. This may be done for two reasons: 

    1. Hedging: Imagine a US company, Company A, wanted to open up a new factory in Canada. It may take out a Canadian bank loan to finance the factory. To hedge its foreign exchange risk, it may want to swap its Canadian interest-rate payments for American ones, so that its payments are always in its own domestic currency. 

    2. Comparative Advantage: Since Company A is based in the US, it can get a US loan much cheaper than a Canadian one. However, it needs Canadian dollars to open its new factory in Canada. This company may take out a US loan and swap its principle and/or interest rate payments with a Canadian company with a Canadian loan that needs USD.  When both the principle and interest rate payment are swapped, the parties are effectively borrowing on each others behalf, and this is called a back-to-back loan. The two parties can also exchange the principle of the loan only at a fixed rate for some future date. These swaps are known as FX-swaps and are more akin to forward or future contracts. 

    Valuing a Swap

    Vanilla swaps are typically priced so that the present value of the fixed legs of the swap are equal to the present value of its floating legs (less the spread that the intermediary institution takes). As a result, the swap has no value to either counterparty and no payments trade hands when the swap is entered into. 



    The present value of the fixed leg is the present value of the fixed coupon payments known at the time of the swap. The present value of the floating leg is calculated by discounting future interest payments using the appropriate forward rate for each payment. Analysts use what they call a multi-curve framework to estimate the appropriate forward rates to discount each future payment. 

    Because forward rates and discount rates may change, the present value of the different legs of the swap may change over time. When this happens, the swap becomes an asset to one party and a liability to another. Swaps are marked-to-market, and corporations that own swaps must include them on their balance sheet when their value deviates from zero. 

    Photo by Ethan McArthur on Unsplash

    © BrainMass Inc. brainmass.com March 28, 2024, 11:58 am ad1c9bdddf

    BrainMass Solutions Available for Instant Download

    Financial Derivatives - Increasing Portfolio Yield

    Imagine you are a money manager hoping to accumulate portfolio yield. Since you anticipate that the current short-term interest rates will increase more than the current yield curve, explain whether you would you rather pay a determined long-term rate and have a floating short-term rate or vice-versa.

    Revenue Recognition and Receivables

    Financial Statement Analysis Part 1 Required: Refer to Eli Lilly's 2012 annual report to answer the following questions. The 2012 annual report of Eli Lilly & Company can be found here: http://www.sec.gov/Archives/edgar/data/59478/000005947813000007/lly-20121231x10k.htm 1. What is Eli Lilly's cash and cash equivalents

    Types of Investors

    Goldman was the short investor for the entire Abacus 2004 CDO: it purchased credit default swap protection on these reference securities from the CDO. The funded investors were IKB (a German bank), the TCW Group, and Wachovia. These banks purchased the mezzanine tranches of the deal. In this situation which parities lose if the

    Risk Management and Hedging Strategy Using Swaps

    A few years back the Government of Japan made the offer to the Government of Brazil: The Brazilian government will give the "Exclusive rights to all the Minerals/ Metals/ and Mining opportunities in Brazil to a consortium of Japanese Corporations for one hundred years to mine, manufacture, extract and sell the commodities. Afte

    Debt-Equity SWAPS

    What are the ethical and political implications for two sovereign nations to be engaged in commodity (debt-equity) swaps? How do you make it win-win situation for all participants?

    Characteristics you want in a dissertation chair and in your committee members

    As you prepare for your upcoming Year 2 residency, take some time to think about the characteristics you want in a dissertation chair and in your committee members. Create and share a list of the top 3 things you hope to find in a chair, and the top 6 characteristics you hope to find between your 2 committee members. Explain y

    Quarterly Swap Payments for ABC Limited

    A manufacturing company, ABC Limited, which makes motor components, has taken a floating-rate loan from its bank and wishes to swap this liability for a fixed-interest rate exposure. Through an intermediary, the company enters into a one-year quarterly-pay £ 2,000,000 fixed-for-floating swap as the fixed-rate payer with counter

    Bond market better than equities or equities better than bonds

    1. If you anticipate the equity market will beat the bond market for the next five years, what swap would you find attractive to contract upon and why. 2. Assuming that you anticipate that the equity markets will outperform the bond markets in the period of three years from today for another three years, what swap is appropri

    Give some examples of team failure.

    1. Conduct a field survey to find out why, despite the evidence that group brainstorming is less effective than solitary brainstorming, do organizations persist in using it as an idea-generating technique? Prepare a report contrasting advantages and disadvantages of both. 2. Give some examples of team failure. Identify the

    Jenny noticed what appeared to be discrepancy in the time sheets

    At Sandwich Blitz, Jenny noticed what appeared to be a discrepancy in the time sheet of one of the customer associates. When she asked the unit manager about this, she learned that the crew supervisor had allowed the associate to swap out work hours against the next time period. After checking the employee handbook which had bee

    Detroit Motors Latin American Expansion: debt-for-equity swaps

    It is September, 1990 and Detroit Motors of Detroit, Michigan, is considering establishing an assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital expenditures has been estimated at $65,000,000. There is not much of a sales market in Latin America, and virtually all output wou

    Stockholders Indifference with Volatile Cash Flows

    1. Give two reasons stockholders might be indifferent between owning the stock of a firm with volatile cash flows and that of a firm with stable cash flows. 2. Discuss some of the techniques available to reduce risk exposures.

    Hedging and Insurance

    Note whether the following are ways to avoid losses through hedging or insuring: Lock in a $979.00 fare home for the holidays. Purchase a put option on a stock you do own. Agree to purchase a house in one year for a fixed price of $200,000. Lease a car with an option to purchase it in three years. Enter into a swa

    Swaps in the Commercial Bank

    A commercial bank agrees to pay a swap dealer a floating rate of interest on a $100 million in exchange for payment by the swap dealer to the bank of a fixed rate of interest on $100 million. At the same time, a manufacturing company agrees to pay the same swap dealer a fixed rate of interest on $100 million in exchange for paym

    Currencies

    22. An agreement to trade currencies based on the exchange rate today for settlement within two business days is called a(n) _____ trade. A. swap B. option C. futures D. forward E. spot

    Introduction to Corporate Finance

    Please help with the following problems. How do managers use options to limit risk exposure? How do managers use swaps to limit risk exposure?

    Negotiation Technique

    You are the international sales manager for a large corporation here in the US. You have been working for months on negotiating a cross license agreement with a large Asian corporation for a product swap. Your CEO, who generally approves of the deal largely on getting the new product: has absolutely no cultural sensitivity, has

    Swap rate and forward premuim

    4. An investor wishes to buy euros spot (at $0.9080) and sell euros forward for 180 days (at $0.9146). a. What is the swap rate on euros? b. What is the forward premium or discount on 180- day euros?

    Swap fixed rates

    What would be the swap fixed rate (SFR) for a plain vanilla, two-year interest rate swap, payments every six months beginning 07/01/0x, with the following assumptions/data: Swap initiation, January 1, 200x FRA1,0 = 2.221%; FRA1,1 = 2.258%; FRA1,2 = 2.322%; FRA1,3 = 2.388%; FRA1,4 = 2.520%; FRA1,5 = 2.632%; (Read the

    Brief analysis of Landry's Inc 10K.

    I just need a brief analysis of Landry's Inc 10K to add to my report. Just give me a few pharagraphs that give the overall analysis of the financial condition of Landry's Inc's 10K include any negatives or positives. The 10K can be found at: http://www.sec.gov/Archives/edgar/data/908652/000119312505052626/d10k.htm

    SWAP

    You are the cash Manager of the International Division of company X.The board has decided to increase sales in Japan. This market share strategy has to be financed in Yen with a fixed rate. You have three possibilities: a) A syndicated $US bank loan facility at LIBOR 3 months + 1/8 percent. b)One Japanese subsidiary of a grea