If you go down memory lane to your childhood days when you played with friends, you will recall instances when you thought your friend’s toy was better than yours. You could of course have snatched it from him after giving him a push. But a more diplomatic way to get your hands on that toy would have been to convince him to exchange it with one of yours. This is what a swap is all about.

Two parties agreeing to exchange their cash flows in such a way that both are benefited, is what a typical swap entails, in the financial sense. Companies, financial institutions and even countries enter into such exchanges. The commonly used swaps are interest rate and currency swaps.

Swaps were in news recently because the Reserve Bank of India introduced a swap window to attract FCNR (B) dollar funds to rescue the beleaguered rupee. The RBI has allowed banks accepting deposits for three years and over, under FCNR (B), to swap the dollars with it for rupees. These rupee funds can be then be used in local operations to generate profit. At the end of the period, banks can pay the RBI the original sum in rupee and get back the dollars. Banks have to pay the central bank 3.5 per cent per annum to bear the currency risk. These are swaps at a macro level. Companies typically use interest rate or currency swaps.

Interest rate swaps

An interest rate swap allows the exchange of one stream of interest payments for another, say a floating-rate interest payment with a fixed- rate interest payment. The interest payments are calculated based on a notional principal. The principal amount is ‘notional’ in the sense that it is used only for the purpose of calculating the interest payments. Let’s take the case of a company that has taken a loan on a floating rate of interest. Now, interest rates are expected to rise. To protect itself from the risk of higher interest costs in future, the company can enter into an interest rate swap with a bank (not necessarily the bank from which it has taken a loan). So, the company (buyer) will payout cash flows at a fixed rate of interest and receive cash flows at a floating rate. This swap will therefore hedge the company against the floating interest liability on the loan it has taken.

Currency swaps

A currency swap is an agreement between two parties to exchange the principal loan amount and the interest payable on that, in one currency with the principal and the interest payments on an equivalent loan in another currency. Let us take the example of a US-based company that wants a rupee loan to fund its Indian operations and an Indian company that wants a dollar loan to fund its US operations. Both the companies can raise loans in their respective countries and swap them. Besides, interest payments will also be swapped. At maturity, the loan amount will be swapped back. The exchange of principals at maturity is generally done at the exchange rate existing at the beginning of the contract, providing protection from exchange rate volatility.

Credit Default Swaps

It is these kinds of swaps, also called CDS that gained notoriety for bringing down many banking behemoths in the sub-prime crisis. CDS is a contract that is used to transfer credit exposure. That is, it works as a hedge against a payments default on fixed income securities such as corporate bonds. For instance, if a bank has invested in the bonds of a company that it believes is likely to default on payment, it can buy a CDS. This helps in swapping or transferring risk from the bond holder (bank) to the seller of the swap. The seller of the CDS is paid a periodic fee for the same.

>maulik.tewari@thehindu.co.in

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