Financial Swaps

1. Financial Swaps DrKishorBhanushali www.ibmajor.wordpress.com

2. Introduction • The term swap refers to exchange • Financial swaps are tools used for asset liability management • Risk management tool • Interest rate swaps and currency swaps are financial swaps which facilitates exchange of assets and liabilities • Financial swaps are asset liability management tool • Swaps are not traded in organized exchange

3. Swaps • Swaps are private agreement between two companies to exchange cash flow in the future according to a pre-arranged formula. • Most common types of swaps: interest rate swaps and currency swaps • Derivative instruments used for hedging the risk • Interest rate swaps (coupon swaps) are used for hedging interest rate risk • Currency swaps are used to hedging the exchange rate risk • Cross currency interest rate swaps

4. Interest Rate Swaps • Fixed interest rate loan exchanged for floating exchange rate loan and vice versa • Fixed-to-floating interest rate swap also called “plain vanilla coupon swap” • LIBOR : London Inter-Bank Offer Rate • MIBOR : Mumbai Inter-Bank Offer Rate • Swapping through financial intermediaries • Motivation : (a) hedging (b) desire to reduce interest rate costs

5. Currency Swaps • Used to transfer loan in one currency into loan in another currency • Liability denoted in one currency and income stream denoted in another currency • Foreign exchange risk • Borrowing and payment in from abroad • Exchanger of principle amount in one currency for the principal amount another currency between two parties at the beginning of the deal • Interest payments in the two currency would be exchanged between the parties at periodical intervals during the tenure of loan • Principle amount will be re-exchanged between two parties at the end of term • Direct negotiation or intermediaries • Used to reduce borrowing costs

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