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Ask Mint | Interest rate swaps: an exchange of cash flows

Ask Mint | Interest rate swaps: an exchange of cash flows
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First Published: Mon, Apr 28 2008. 12 22 AM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Mon, Apr 28 2008. 12 22 AM IST
The world of derivatives is neither round nor flat. It is rather spread out like bits and pieces of a big jigsaw puzzle. One piece is here but another piece may be hiding somewhere else. If you want to see the complete picture, you have to put all the pieces together. A few weeks ago, Jinny provided Johnny some insight into futures and options. She now tells him about another kind of derivatives contract: interest and currency swaps.
Johnny: Hello, Jinny! You seem to be in a singing mood today. What’s the matter?
Jinny: Yes, I am today in a mood to sing a swap song. The best song ever dedicated to interest rate and currency swaps.
Johnny: A swap song? I never thought that like a swan song we could also have a swap song.
Illustration: Jayachandran / Mint
Jinny: You can appreciate the uniqueness of interest rate and currency swaps only when you understand what they are and how they work. Some feel that understanding these swaps requires superhuman intelligence. But you need not worry; understanding them just requires a few minutes’ chat with Jinny. Interest rate and currency swaps are a kind of over-the-counter derivatives contract that parties enter into through private negotiations. The parties themselves decide the contract size, maturity date and other terms and conditions as per their need.
In such contracts, parties agree to exchange future cash flows with each other. The exchange of cash flow mostly takes place on the basis of variables such as interest rates or exchange rates. These swaps, in general, work like currency forward contracts but with one big difference. Currency forward contracts involve the exchange of cash on a fixed date whereas interest rate and currency swaps involve exchange of cash flows on several future dates. Suppose you enter into a forward contract to sell $100 at the fixed exchange rate of Rs45 for $1. On the delivery date, you simply exchange one form of cash—dollars—with another form of cash—Indian rupees—and your contract comes to an end. But, in the case of interest rate and currency swaps, cash exchange takes place on several dates.
Johnny: What kinds of cash flow exchanges take place in interest rate and currency swaps?
Jinny: Let’s talk about interest rate swaps first. For the sake of simplicity, we are considering the working of plain vanilla interest rate swaps which are of the most simple kind. In the case of plain vanilla interest rate swaps, parties agree to swap cash flows originating out of a fixed rate of interest with cash flows originating out of a floating rate of interest or vice versa. For calculating the cash flow, parties use a notional principal amount. The principal amount is notional because interest rate swaps do not involve actual exchange of the principal amount.
Then, how does it work? Let’s try to understand by taking an example. Suppose company A has borrowed money at a fixed interest rate but wants to convert it into a loan on floating interest rates. Suppose there is another firm, company B, which has borrowed the same amount on floating interest rates but wants to convert it into a loan on fixed interest rate. Why are companies A and B not happy with their respective loans? A case of the grass being greener on the other side? Maybe the companies got locked in loans of different kinds than what they originally wanted due to reasons beyond their control, such as poor credit rating, short-term interest rates fluctuations, etc. Maybe both the companies are now working on different assessments of future interest rates. Company A thinks interest rates will fall and hence, a loan on floating interest rates would entail lower interest payment. Company B, however, thinks interest rates would rise, making the loan on floating interest rates a costlier affair in terms of interest payments. The choice for both companies seems obvious. Companies A and B swap their loans. As the principal loan amount is common for both companies, there is no need to swap it. The companies merely agree to swap fixed for floating interest rate with each other. Company A will receive interest payment on a fixed rate from company B on the principal amount and pass it on to its lenders. Similarly, company B will receive interest payment on floating rate from company A and pass it on to its lenders.
In effect, company A has converted its fixed rate loan into a floating rate loan whereas company B has converted its floating rate loan into a fixed interest loan. Swaps really help you enjoy the Song of Sixpence from the other side of your big fence. This makes interest rate and currency swaps unique in the world of derivatives.
Johnny: You are right, Jinny. Swaps are really unique. I will ask you about currency swaps next week.
What:Interest rate and currency swaps are agreements in which parties agree to exchange cash flows with each other.
How: Swap agreements are entered into through private negotiations in which parties themselves decide the terms and conditions.
Why: Interest rate swaps are useful because they help in converting a fixed interest rate loan into a floating interest rate loan and vice versa.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Mon, Apr 28 2008. 12 22 AM IST