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December 15, 2016 | 14:45 | Dubai
Think of it as an agreement between two parties. This agreement involves an exchange of future cash flows. The easiest way to understand the concept is by way of getting into an example. Let’s say you in a discussion with your friend, both of you’ll having coincidentally purchased a house around the same time 2 years back, having availed of a loan, come to know that while you have opted for a fixed interest rate, your friend is paying a floating interest rate. In the current interest rate regime, witnessing lower rates, you are stuck with a higher rate, based on what prevailed then. All things staying constant, amount of the loan taken and the tenure of the loan, you are wishing you could swap your loan with his and take onus of his cash flows and he takes responsibility of yours. This is how a swap works. It can be thought of a way of exchanging loans.
Taking this example further to an actual context of the most commonly prevailing swaps. Let’s say company ABC issues AED 1 million in 20 year corporate bonds with a floating interest rate of 12 month LIBOR + 100 basis points. The respective LIBOR rate currently is, say, 1.70%, so Company ABC pays bondholders 2.70%.
After issuance, Company ABC realizes after some passage of time, that LIBOR may trend higher over the coming months. To offset this risk, the company enters into an agreement with an Investor PQR. This is a swap agreement. How it works it: Company ABC agrees to pay the investor PQR 2.90% on AED 1 million each year for 20 years. Investor PQR agrees to pay Company ABC, LIBOR + 1% on USD 1 million per year for 20 years (this matches ABC’s obligation towards its bondholders). The investor PQR opines that interest rates are headed lower, which is why entering into the Swap makes sense for him.
Reasons to enter a Swap are many:
While above, we discuss only an interest rate swap, swaps are immensely popular in the forex market too. A forex swap is a simultaneous purchase and sale of identical amounts of one currency for another. Swaps form an essential part of