Exploring Interest Rate and Currency swaps
Discover how interest rate and Currency swaps can supercharge your investments and your finances.
Hello readers,
In this post we will try to deep dive into the world of derivatives through the means of interest rate and currency swaps. Let’s start.
What do they mean and how do they work?
Financial swaps are commonly defined as an exchange of a stream of cash flows or a portfolio or a series of off market forwards (i.e. they do not have zero value to begin with).
Since it is an Over The Counter (OTC) derivative, it is customized and comes in various types, prominent 2 types being the Interest Rate and Currency Swaps.
Interest Rate swaps
Interest rate swaps are constructed by parties looking to hedge or speculate basis interest rates.
Let us understand with an example.
Let’s say there are two parties Mr. A & Mr. B and out of these two, A is bullish on LIBOR/MIBOR and (i.e. London/Mumbai Inter Bank Offered Rate which is a floating rate and not a fixed rate and so it keeps on changing) and he predicts that LIBOR or MIBOR will rise in the near future and B is bearish on LIBOR/MIBOR and expects it to fall. So they both enter into a swap agreement where A agrees to receive LIBOR/MIBOR on a notional principal amount (this principal isn’t actually exchanged in the agreement but is just for the purpose of the calculation of differential amount) and B agrees to receive a fixed rate of interest (say 8%) on the notional principal. Note that A agreed to receive LIBOR/MIBOR as he expected it to rise and B agreed to receive a fixed rate as he expected LIBOR/MIBOR to fall below the fixed rate agreed by him.
They agree thee swap term to be one year from 1st Jan 2023, payment being every 4 months, advanced set payable in arrear [i.e. LIBOR/MIBOR will be set on the beginning of the 4 months (1st Jan) and net payment will be made at the end of 4 months i.e. 30 April] and notional principal will be $500 million.
Now let us calculate the payments:
Interest rate swaps can also be an effective tool for hedging for institutions like banks.
Let’s say that a bank has fixed rate assets with LIBOR/MIBOR linked deposits or vice versa agree the terms of a swap where it will pay a fixed rate and will receive LIBOR/MIBOR or vice versa.
So it will quote a swap at let us say 8%/8.2% (i.e. it will pay at 8% fixed and will receive at 8.2% fixed if it is on the fixed interest rate leg of the swap)
Currency swap
In a currency swap, things work similarly to that of a plain vanilla interest rate swap just for some tweaks. There is an actual exchange of principal amounts at the beginning and at the end of the swap period as against the notional principal in the interest rate swap.
Let us say there are two parties A and B to the currency swap. An exchange rate of 1/2 GBP/USD is quoted and accordingly A borrows 500M GBP from B at 5% and B borrows 1000M USD from A at 6%. It involves actual transfers of the interest payment without netting as in the case of interest rate swaps. Thank you for your patient reading.
Will see you soon in another write up.