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Swaps: A Study of Investment Hedging with Swaps

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Added on  2020-01-07

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INVESTMENT ANALYSIS METHODS 3 METHODOLOGY 3 Meaning of swaps 3 Benefits of swaps3 Main types of swaps, analysis and findings4 Interest rate risk hedging with the use of swaps5 Currency risk hedging with swap7 CONCLUSION 10 RECOMMENDATIONS 11 REFERENCES 12 INTRODUCTION In the present market, changes take place at a faster rate because of complexity and uncertainty in thebusiness environment.Therefore, organization uses variety of financial instruments such as swaps, futures and forward contracts etc. Hence, under

Swaps: A Study of Investment Hedging with Swaps

   Added on 2020-01-07

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INVESTMENT ANALYSIS
Swaps: A Study of Investment Hedging with Swaps_1
Table of ContentsINTRODUCTION......................................................................................................................3METHODOLOGY.....................................................................................................................3Meaning of swaps ............................................................................................................3Benefits of swaps..............................................................................................................3Main types of swaps, analysis and findings......................................................................4Interest rate risk hedging with the use of swaps...............................................................5Currency risk hedging with swap.....................................................................................7CONCLUSION........................................................................................................................10RECOMMENDATIONS.........................................................................................................11REFERENCES.........................................................................................................................12
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INTRODUCTIONIn the present market, changes take place at a faster rate because of complexity anduncertainty in the business environment. Therefore, organization uses variety of financialinstruments such as swaps, futures and forward contracts etc. to hedge different types ofbusiness risks. Out of these, swaps is greatly using in the present market. It is a derivativecontract in which two counter parties can exchange their financial instruments to mitigatetheir risks. Present project report will discuss the application of distinct types of swaps and itsbenefits in the corporation. Moreover, the report will make in-depth evaluation that howswaps can be used to hedge risks such as currency and inflation risks in the business. METHODOLOGYMeaning of swaps Swaps is a derivative contract through which one party can exchange their cash flowsassociated with their financial instrument with other person. It is a contract in which twoparties will be agreed to exchange their financial instruments with each other on apredetermined date that is specified in the contract. It is greatly using in the current market byall the business organizations to hedge against risk (Aıt-Sahalia, Karaman and Mancini,2014). Swaps contract can be made for different types of financial instruments but essentialthing is that cash flows on one financial instrument must be fixed and other must beuncertain. For instance, in case of financial instrument that has fixed interest rate, theirassociated cash flows will be certain. While, in case of instrument that has floating interestrates, their associated cash flows will be uncertain. But still, notional principal amount onboth the financial instruments will be fixed and it will not be exchanged by both the counterparties. Swaps are generally traded on over the counter (OTC) market between privatebusiness entities (Kiesel, Lücke and Schiereck, 2015). In this contracts, difference betweencash flow streams is called swap legs. Benefits of swapsSwaps provides number of benefits to the private entities, some of them are described below:Risk management: Swaps greatly helps to reduce business risk so managing risk isone of the most important benefits of swaps contracts (Biffis and et.al., 2015). For instance,exchanging floating interest bearing security with the fixed interest bearing security eliminaterisks that can be arise due to volatility and fluctuation in interest rate. Thus, hedge against
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risk will result in rising profitability, potential and business performance as well. This in turn,both the parties will be able to take benefits of improved financial position. Financing access: Swaps also helps to provide advantage of financing access throughvariable interest rate rather than fixed borrowings (Filipović, Gourier and Mancini, 2016). Itenables firms to enlarge their credit worthiness as per the management desires. Cheaper: Swap includes some premium charges which counter parties need to be payas their transaction costs. Hence, very low amount of premium provides facility to hedge riskat very cheaper rate. Long term benefits: Swaps contract can be done for a longer duration comparativelythan other contracts such as future and forwards. It is because under the swap contracts,counter parties can agree to exchange their cash flow streams with the cash flows of otherparty's financial instrument till the maturity period which is often very longer period(Arentsen and et.al., 2015). Thus, it is clear that swaps contract facilitates benefits for longerperiod. Main types of swaps, analysis and findingsThere are wide range of swaps which can be used by the businesses to mitigate their risks, these are explained below:Interest rate swaps: It is a contractual agreement between two parties who are agreedto exchange their financial instrument's cash flows with other person. In swap contracts, legsare defined as series of related cash flows on party's financial assets such as bonds. Under theinterest rate swaps, one party's financial instrument contains fixed cash flows in terms offixed interest rate while other party's financial instrument has floating interest rate (Mele andObayashi, 2015). Hence, cash flows on fixed interest bearing security is known in advanceand cash flows on floating interest bearing security is an uncertain or random. Henceforth, inthis contract, counter parties will be agreed to exchange their fixed series of cash flows withthe other party's unknown cash payments. It helps to reduce risk against volatility in floatinginterest rate through exchanging it with those of the other party's assets that have fixedinterest payments. Interest rate swaps focuses on all the conditions such as notional principalamount, accrual method, effective date of contract, contract termination date, cash flowfrequency and basis of floating interest rate to administrate swaps effectively. Interest rateswaps can be contracted for exchanging fixed cash flow stream with the floating interestseries (Byun and Chang, 2015). In the present market, interest rate fluctuation can be seen at
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