As Kuprianov (1994) claimed that an interest rate swap is an agreement between two parties to exchange a series of interest rate payments without exchanging the underlying debt. Fehle (2002) said, "interest rate swaps (hereafter swaps) are over-the-counter agreements between two counterparties to exchange periodic interest rate payments based on a predetermined notional amount." One counter of those parties (hereafter swap buyer) makes a fixed interest payment, typically called the swap rate or swap coupon, whereas the second counterparty (hereafter swap seller) makes its interest payment based on a floating-rate index like the London interbank offered rate (LIBOR). Massimiliano De Santis (2011) believe that "An interest rate swap is a periodic exchange of fixed coupon payments by one counterparty (called the fixed-rate payer) in return for variable-rate payments by another counterparty (called the floating-rate payer), until a stated maturity." Clive Grumball (1987) pointed that interest rate swap is: "a transaction where two unrelated borrowers independently borrow identical principal amounts for the same period from different lenders and with interest calculated on a different basis, and agree to make payments to each other based on the interest cost of the other's borrowing."
Through the above definition, in general words, interest rate swap is an agreement between two parties which want to exchange their interest rate payments styles like the floating rate payment could be based on 6-month LIBOR The aim of this economic activity is to avoid interest risk. (London Interbank Offered Rate). For example, there are two institutions A and B. Their relationship as the following picture shows:
Fig 1
Resourse:http://upload.wikimedia.org/wikipedia/commons/1/1c/Vanilla_interest_rate_swap.png
According to fig.1 it is can be clearly see that Party A should pay LIBOR+1.5% floating interest rate, but it wants to pay fixed. Party B should pay 6.5% fixed interest rate, but it wants to pay floating. Through interest rate swap, Party A pays the fixed rate which is 5% for Party B and Party B pays the LIBOR to Party A. So Party A paid 6.5% fixed rates and Party B paid LIBOR+1.5 floating rates in the final.
Fig. 2
In most cases, parties will not deal interest swap directly. They will do this business through banks. Party A and Party B do not want to exchange their interest rate payment however they are hard to find acceptable counter-parties. So they swap their interest rate through bank which as a financial intermediary. (See Fig. 2)
Using Interest rate swap to manage risk
Most swaps are entered with dealers, who then seek to limit their exposure to interest rate risk by entering into offsetting swaps with other counterparties.
Interest rates are unpredictable, especially over the long run. An interest rate swap can help protect the issuer of bonds, treasuries, or loans against interest rate risk by transferring the risk to another party in exchange for a variable payment. For instance, Company A has a $1000 loan with bank and it should pay floating rate. However, A predicts that the floating rate will rise in the future. This means that A has to pay more to bank. To avoid this risk, Company A make a interest rate swap with bank, which change floating rate into fixed rate. By the contrary, when A predicts floating rate may decline, A would like to keep floating rate. Then A will pay less than before in the future. In another word, if Company A have loan contract which use fixed rate with bank, it should keep this type of repayment when it predicts interest rate will rise and change into floating while it predicts interest rate will decline in the future.
Massimiliano De Santis (2011) pointed out that interest rate swaps offer a borrower potential cost savings justifiable on economic grounds; they may also expose him to risks not present in other financing alternatives. As this article mentioned above, it is can be clearly see that Interest Rate Swap (IRS) is a kind of tool to manage interest rate risk. Mishkin and Eakins (2006) claimed that IRS is a set of interest payment which could default risk and liquidity problem. There will be a case-study on an interest rate swap between State Grid Corporation of China and Bank of China as follows:
State Grid Corporation of China invested approximate 3 billion dollar, which include $165.11 million long-term loan with around 6.5% fixed rate from Asian Development Bank. The corporation entry repayment in 2000 and it still should repay 151.99 million dollar after 1st May, 2003. Because of huge debt capital and long-term debt maturities, the corporation may face the interest rate risk which is the wide fluctuations of U.S. dollar interest rate. This may cause State Grid Corporation of China pay a higher interest.
Through analysis of U.S. dollar interest market, the interest rate of dollar had reached the lowest point during these ten years, which means that U.S. dollar may have a dramatically rising in the next ten years. The reason why U.S. dollar interest rate decrease in a sharply way is that the Terrorist attacks America and the military crisis in Iraq effect long-term U.S. dollar interest rates which is continue to decline. During the last 3 years, American 10-year swap rate have a downward trend from 7.0% to 4.0%, which declined almost 50% rate. It is rarely to see that the long-term interest rate have this decreased trend. After these analyses, the corporation believes that U.S. dollar only has little space to decrease than increase. To against the probably interest rate risk which leads by increasing of U.S. dollar interest rate, the company decided to change its interest rate payments through swap.
Fig. 3
Through analysis the situation of debt of this corporation, Bank of China has made an interest rate swaps hedging program for State Grid Corporation of China, which fixed the 10-year interest rate on 4.2% that is lower than currency interest rate (6.5%). This swap could save 6.9 million debt cost for the company. After swap, the 10-year interest rate start to up and down around 5%. Then State Grid Corporation of China has hedged interest risk via the swap.
Definition of Foreign Currency Swap
Clive Grumball (1987) said that currency swap actually is "extension of the back-to-back or parallel loan" and currency swap has some of the characteristics of a parallel loan, but is a simpler than parallel loan. It is also different from back-to-back loan. In general words, both parallel and back-to-back loan belong to loan activities, which will create new assets and liabilities in the balance sheet. However, currency swaps as a business that irrelative to statement of assets and liabilities, which can achieve the same aims and have not any influence to the statement of assets and liabilities. (Clive Grumball, 1987) Howcroft B. (???) mentioned that "currency swap is a legal arrangement to exchange payments denominated in one currency for those denominated in another, typically for a period of between two and ten years". Through analysis the definition mentioned above, foreign currency swap is that an agreement on exchange number of two kinds of currency within the prescribed time limit. At the same time, the involver also should pay for the two kinds of currency interest regularly. In fact, foreign currency is a financial derivative which likes a tool to manage foreign exchange risk.
Foreign currency swap has some characters. Firstly, the rate of foreign currency swap can change from fixed to floating vice versa and the fixed also can change into another fixed rate. Secondly, during currency swap, involver could choose spot rate or forward rate. Thirdly, the exchange of original capital could be leaving out in the beginning of swap. The loan which has been used can manage risk through currency swap.
Cross currency swap is a further refinement of the parallel loan and the currency swap and involve a combination of interest rate and currency swap. It is operating through exchange currency between two counterparties or between two counterparties via an intermediary such as bank. The concept of currency swaps and cross currency swaps has been around for some little while and many banks and institutions lay claim to have been amongst the originator of this particular product.
Foreign currency swap have several purpose such as managing statement of assets and liabilities, achieving profit through speculating. It is also could give a chance to avoid the barrier which created by some governments that entry some other countries' capital market. However, the most important usage of currency swap is maximizing profit through managing exchange risk and reducing financing cost.
Management risk by foreign currency swap
The first question should be answer is the definition of exchange rate risk. Philip Gray and Timothy Irwin (2003) gave their opinions, "There are two types of exchange rate risk: project and financing related. Project exchange rate risk arises when the value of a project's inputs or outputs depends on the exchange rate. So any input that is tradable, even if it is not imported, will have a world price, so its cost, measured in local currency, will vary inversely with the exchange rate. The cost of fuel, for example, creates exchange rate risk for a thermal electricity generator."
To reducing the foreign exchange risk, a variety of techniques have been created to make counterparties against foreign exchange risk. Most of these techniques are based on theory of undertaking an offsetting transaction in a derivative, such swaps. (Peter Howwells and Keith Bain, 2007) Exchange rate risk management is an integral part of every ï¬rm's decisions about foreign currency exposure (Allayannis, Ihrig, and Weston, 2001).
The operating of foreign currency swap is more complicated than interest rate swap. As mentioned above, currency swap is another-- Peter Howwells and Keith Bain (2007) believe that currency swap has three basic stages as follows:
Firstly of all, it is initial exchange of principle. It is mean that two of counterparties decided an exchange principle amounts at an agreed exchange rate. Howcroft, B (--) mentioned that this rate usually followed the spot exchange rate or use the mid-rate and a forward rate which set before the swap commencement date can also be used.
In the second place, once the principal amounts are established, the counterparties exchange interest payments based on the outstanding principal amounts and agreed fixed interest rates. Howcroft, B (--) named the stage as "ongoing exchanges of interest".
The third stage is re-exchanged of principal amounts at a predetermined exchange rate so the parties end up with their original currencies.
The case study can illustrate how foreign currency swap hedge risk, which is about a Japanese company gained Japanese 7-year currency loans (one billion) from its parent company on 20th December in 2001 having a currency swap with a bank. The fix rate of the loan is 2.25% and the interest payment date is 20th June and 20th December every year until 20th December 2008. However, the company should use dollar to purchase production facilities, so it is should change Japanese yen into dollar. Also the income of exporting product only is dollar. This means that the company have FX risk.
To reduce the exchange risk, the company decided to have a foreign currency swap with a bank. As its agreement claimed that this swap transaction from 20th December in 2001 to 20th December in 2008 and the using of exchange rate is 1 U.S. dollar=123 Japanese Yen. This swap agreement has three significant points. Firstly, the company and the bank should exchange original capital with promissory exchange rate in 20th December 2001. Secondly, the company and the bank should exchange interest in every 20th June and 20th December until year of 2008, which means the company should afford interest of U.S. dollar to bank, and the bank should pay interest of Japanese yen to the company, the company cash out to its parent company for repay loan. Thirdly, the bank and the company should re-exchange original capital with same exchange rate using in the effective date during maturity date when is 20th December in 2008.
As it is can be seen from above, the company and the bank exchanged original capital with the same exchange rate in the beginning and ending of the transaction. In the period of the loan, the company only need to afford interest of U.S. dollar, and the income of yen interest can be used for repay the loan created by parent company. Thus the company can completely hedge the exchange rate risk.
