What is a swap transaction?
Types of swap transactions:
There are two types of swap transactions. One is currency swap and the other is interest swap. These can be better explained with the following examples.
Currency swap in swap transaction:
In this type of swap transaction, the foreign currency rate may be taken advantage of by banks due to the arbitrage. An arbitrage is the difference in the exchange rate between two different markets. We can explain the currency swap by the following example.
In India, a bank may have 6,000 U.S. dollars. The exchange rate prevailing in India for 1 U.S. dollar = INR 66, Pound Sterling = Rs. 100. So, the cross exchange rate between Pound Sterling and Dollar in India is 1 Pound Sterling = 1.52 U.S. dollars.
Suppose, in London market, 1 Pound Sterling = 2 U.S. dollars, the commercial bank in India will first convert 6,000 U.S. dollars into rupee and obtain INR 396,000. For this amount, it will buy Pound Sterling amounting to 3,960 Pound sterling. This will be taken to the London market and converted into dollars at 2 U.S. dollar per Pound Sterling. The bank will be able to obtain 7,920 U.S. dollars. This will be brought back to India. Thus, in the process of swapping, the bank continues to hold dollar but instead of holding 6,000, it has now have 7,920, an increase of 1,920 dollars. This is what we call currency swap. Thus, when 2 currencies are exchanged in swap, it is called cross currency swap.
Interest swap in swap transaction:
Suppose, a person takes a housing loan in 2000 at 17% interest rate, he can approach a bank now for taking over his old loan for a fresh loan at a lesser rate of interest. The bank will settle his loan with his previous creditor and takes over the security. The borrower is now in the same old position, but his loan with the bank carries a lower rate of interest. This is known as interest swap. This is made possible due to floating rate of interest and in a floating rate of interest, the interest rate gets reduced according to market conditions. The borrower switches over from a fixed to floating interest rate and gains. This is the advantage of swap transactions.
Types of Interest Swaps in swap transaction:
There are 3 different types of interest swaps.
- Fixed to floating rate of interest.
- Floating to floating rate of interest.
- Fixed to fixed rate of interest.
A fixed rate of interest is one where the interest on the loan does not change until the loan is settled. But in the case of floating interest rate, the interest rate fluctuates according to the market forces of supply and demand. As a result, the interest rate may go down or it may rise also. But, when the interest rate comes down, the borrower can take advantage of it by swapping it with the help of the lender.
- In the first case of fixed to floating rate of interest, the borrower takes the advantage of floating rate by switching over from the fixed interest rate.
- In the second case (floating to floating rate of interest), one floating interest rate may be lesser than another floating rate or one market floating rate may be lesser than another market floating rate and so the borrower takes advantage of it.
- In the last case of fixed to fixed rate of interest, the existing return on a government bond may be lower and a future bond may have a higher fixed return and so the investor takes advantage of it by swapping the existing one to the future one.
Here is an useful link where you can find the 30-year Dollar Interest rate swap chart.
Benefits of Swapping in swap transaction:
The following are the benefits of swapping in a swap transactions.
- Swap transaction reduces the cost of borrowing as the borrower can take advantage of lower rate of interest.
- Investors can be benefited by switching over their investments to different securities in swap transaction which provide higher return.
- In a swap transaction, the fluctuations in the exchange rate, can be smoothen out by swapping currencies.
- Capital market helps investors by swapping contracts to minimize their loss.
- The development of information technology has made swap market more attractive and global transactions could be made instantly through internet.