Analysis of Interest Rate, Currency, and Credit Default Swaps

This report provides a detailed analysis of interest rate swaps, currency swaps, and credit default swaps (CDS). It explains how interest rate swaps enable companies to exchange interest rate payments, hedging against risk, and often resulting in a zero-sum game. Currency swaps, on the other hand, focus on hedging foreign currency exchange rate fluctuations, particularly for institutions with future foreign currency cash flows. The report illustrates these swaps with examples, such as two firms swapping fixed and floating interest rates and companies in different countries exchanging currencies to mitigate foreign exchange risk. Lastly, the document explains credit default swaps, which transfer the risk associated with credit defaults of fixed income securities, detailing how the buyer makes payments to the seller until maturity, with the seller assuring payment in case of a credit default. Examples are provided to clarify the mechanics of CDS contracts, including scenarios where a bondholder uses a CDS to protect against potential issuer default.

FINANCE & INVESTMENT
SWAP
STUDENT ID:
[Pick the date]

Interest Rate Swap
An interest rate swap is defined as a financial derivative which is deployed by the companies
for the exchange of interest rate payment with one another. The interest rate swaps are useful
only when there are two parties one which wants to receive a payment linked with the
variable interest rate and another party who wants to receive a fixed rate of interest thereby
reducing the underlying risk. Theoretically, it acts as a win-win situation for both the parties
involved. This is because one party is able to hedge the underlying risk of floating interest by
being able to avail a mutually agreed fixed rate of interest whereby the other party gets to
hold a conservative asset with potential rewards. Also, it is noticeable that interest rate swaps
tend to lead to a zero sum game where one party would benefit and the other would lose
based on the prevailing interest rate at the time of determined date when maturity of swap is
achieved. The interest rate swaps are traded over the counter and agreement between the
buyer and seller is required with regards to two main aspects i.e. swap length (which would
ascertain the maturity date) and swap terms (including frequency of payments along with
underlying structure). An example of interest rate swap is demonstrated as shown below.
Consider there are two firms i.e. ABC Ltd and XYZ Ltd. They enter into an interest rate swap
with a nominal value of $ 10 million and maturity of 1 year. XYZ is offered an annual fixed
rate of 5% by ABC while in return ABC would be received LIBOR +2% as the two parties
believe that LIBOR should be around 3%. Assume that at the end of the maturity period of
interest rate swap, the LIBOR is 2.75%, thus XYZ would be given 5% of $10 million or $ 0.5
million as interest payment by ABC. However, XYZ would pay (2.75% +2%) or 4.75% of $
10 million or $ 0.475 million as interest payment to ABC. In the process, XYZ gains $ 0.025
million since LIBOR decreases where ABC lost the same amount.

Currency Swap
As the name suggests, the focal point of these swap instruments is the currency exchange
rate. The objective of entering into a currency swap is to hedge the risk related to fluctuations
in foreign currency exchange rate. Unlike interest swap where the focus was on interest, the
currency swaps tend to focus on the principal component. These are usually entered into by
institutions that have a visibility with regards to receipt of foreign currency cash flows at a
particular date in the future. The currency swap tends to have a particular maturity date where
the two parties would tend to exchange foreign currencies at a pre-determined rate at the time
of entering into the swap agreement. For example if one party based in UK is expected to
receive $ 15 million on a given date and on the same date, another party based in US is
expected to receive £ 10 million, then they can enter into a swap at an agreed fixed swap rate
which would reduce the foreign currency risk for both the parties involved. It is noteworthy
that for the foreign debt assumed by the parties, the respective parties also tend to make the
periodic payment and hence foreign currency exchange risk is not mitigated for the principal
but also for the interest payment.This can be made clear from the following example.
Let us consider a company named ABC Pty Ltd based in UK which is expected to repay a
USD 10.5 million loan at the end of one year. There is another company XYZ Inc based in
USA which has to repay a £ 7 million loan at the end of one year. The two parties can enter a
currency swap with a maturity period of one year with the notional amount of USD 10.5
million or £7 million at the agreed exchange rate of £1 = USD 1.5. The currency exchange
rate at the agreed maturity date may be difference from that agreed at the time of swap but the
parties would need to make the payment at the rate settled in the currency swap. Further, the
two parties would also cover the interest payments that would arise before the repayment of
principal amount.

Credit Default Swap
The credit default swap is a financial instrument that is aimed to transfer the risk associated
with credit default with regards to fixed income securities. Thus, the buyer of the credit
default swap would make payments to the seller of the swap and these would continue till the
maturity of the swap contract. The quantum of these payments would be dependent on the
credit rating of the underlying debt security at the time of entering into the CDS contract.
Typically debt securities with higher risk of default would attract a higher premium that is
payable by the buyer to the seller. The seller of the swap provides assurance to the buyer that
if there is a credit default, then the seller would make the payment comprising of the
premium on the security coupled with the interest payments till the maturity of the security to
the buyer. However, it is noteworthy that the interest payments are potentially covered to the
extent of CDS contract duration. The working of a CDS can be illustrated from the following
example.
Consider an individual A who has purchased a $1 million bond with a coupon of 5% p.a and
maturity of 5 years.. A is concerned that the bond issuer may default and wants to cover the
risk and hence enters into a CDS with B. The annual interest payment on the bond would be
$0.05 million. B demands $ 0.005 million p.a. in order to enter into CDS with a maturity of 5
years. During this time, if there is a default on the bond, then B would pay A, the $1 million
principal payment along with pending interest payments at the time of default. On the other
hand, if there is no default, then B would make a profit of $ 0.005 million per year for five
years.