Derivative investment

Topic: swaps

Members:
Adeel Pervez
Sameer Ahamad
Zeeshan Shaikh
 Swaps
• An exchange of one thing for another
• A contract between two parties to exchange
two streams of payments for an agreed period
of time.
• Swaps are arranged in many different
currencies and interests for different periods
of time
 swaps
• The swaps market has had an exceptional
growth since its inception in 1979.

• The swaps volume exceeds $10 trillion today.

• Swaps not only often replace other derivative

instruments such as futures and forwards, but
also complement those products.
 Market survey
• IN THE PAST TWO decade’s financial derivatives, including futures,
options, and interest rate and currency swaps, have become important and
useful instruments in risk management for financial institutions and
business firms. After the recent reports of large losses by Proctor and
Gamble, Gibson Greetings, Orange County, and others, a great deal of
attention has been given to the discussions of the benefits and costs of
financial derivatives. Since their introduction in the early 1980’s, interest
rate swaps have become one of the most powerful and popular financial
tools for transferring and hedging risk for banks and business corporations.
The market for interest rate swaps has grown very rapidly in the past
fifteen years. As of the end of 1994 the notional amount of outstanding
interest rate swaps was more than $8.8 trillion
 Reason for the growth of swap market
• Interest rate swap create a link between distinct markets with
differential access to fund sources creating globalization of
finance markets.
• Interest rate swaps provide a way to reduce the total funding
cost for debt.
• Interest rate swap is flexible and convenient way for
companies to manage balance sheet and reduce the mismatch
between the maturities of assets and liabilities.
• Swaps are desirable because they minimize the costs of
regulations and tax loans.
 Facilitators
• The swaps dealer earns the difference between
the amount received from a party and the
amount paid to the other party.

• The dealer would offset his risks by matching

one swap with another to streamline his
payments.
Basic types of swaps
 Currency Swap
• In a currency swap, the parties to the contract exchange the
principal of two different currencies immediately, so that each
party has the use of the different currency.
• They also make interest payments to each other on the
principal during the contract term.
• one of the parties pays a fixed interest rate and the other pays a
floating interest rate, but both could pay fixed or floating rates.
• When the contract ends, the parties re-exchange the principal
amount of the swap.
• currency swaps were used to give each party access to enough
foreign currency to make purchases in foreign markets.
 Currency Swap
• Difference is that currency swaps usually involve
exchange and re-exchange of principals whereas
interest swaps don’t

Currency swap has three set of cash flows

• The initial exchange of principals at the beginning
• The exchange of interest payments during the
contract period
• The re-exchange of principals at the end.
At Inception

On each settlement date (Int payment)

At Maturity
 Example
• Suppose a U.S. MNC wants to finance a
£10,000,000 expansion of a British plant.
• If the spot exchange rate is S0($/£) = $1.60/£,
the U.S. firm needs to find a British firm
wanting to finance dollar borrowing in the
amount of $16,000,000.
• firm A is a U.S.–based multinational and firm B
is a U.K.–based multinational.
Example
 Comparative Advantage
• A is the more credit-worthy of the two firms.
• A pays 2% less to borrow in dollars than B
• A pays .4% less to borrow in pounds than B
• B pays 2% more to borrow in dollars than A
• B pays only .4% more to borrow in pounds than A
• A has a comparative advantage in borrowing in
dollars.
• B has a comparative advantage in borrowing in
pounds.
 Reason for using Curr. Swap
• Currency swaps may be used to hedge against
foreign exchange risk.
• Entering restricted capital markets
• A firm may be able to use their surplus funds
more effectively in blocked currencies.
• It is used because Supply-demand imbalances in
the markets
• Currency swap can be used as a mean of
exploiting arbitrage opportunities.