Fixed-for-Floating Swaps: Domestic and Foreign Currency Transactions

This is part 3 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 and 2, we discussed the beginnings of swaps as well as the differences between interest rate swaps and currency swaps. In part 3, we’ll discuss fixed-for-floating swaps. 

Fixed for Floating Swaps

This is a chart provided in the March 1987 Federal Reserve paper “Interest Rate Swaps: Risk and Regulation,” by J. Gregg Whitataker. It remains perhaps the simplest and best diagram to date on how a fixed-for-floating swap works.

But before we jump into some math, we should reestablish the basic motivation behind swaps: comparable advantage. For example, if the party (party A) holding the floating rate instrument believes rates will increase in the short-term while the party (party B) holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations. Thus, once the swap is complete, party A is ‘long the fixed rate, short the floating rate,’ while party B is ‘short the fixed rate, long the floating rate.’

The aforementioned example is a plain vanilla swap, a fixed-for-floating swap involving only one currency (i.e. a swap agreement involving two companies using the same domestic currency). Let’s say party A wants to take out a loan, at 12% and a floating rate of LIBOR +2% (but would really prefer a fixed rate). Conversely, party B wants to take out a loan, at 8% and a fixed rate of LIBOR +4% (but would really prefer a floating rate). By using a fixed-for-floating swap, both party A and party B can exchange obligations and receive their respective desired interest rates.

While fixed-for-floating swaps involving one currency are simple, they become slightly more complicated when involving more than one currency. As the name suggests, fixed-for-floating swaps in different currencies involve exchanging a fixed rate in one currency (i.e. U.S. Dollars) for a floating rate in another currency (i.e. Euros).

For example, if a company A has a fixed rate $50 million loan at 6.5% paid monthly and a floating rate investment of €75 billion that yields EUR 1M LIBOR +75-basis points monthly, and is worried about exchange rate fluctuations, it may choose to enter a fixed-for-floating currency swap with another firm, company B. In this example, company A wants to ensure profit in U.S. Dollars as they expect one of two things to occur: either the EURUSD exchange rate to drop; or the EUR 1M LIBOR to drop. By entering a fixed-for-floating currency swap with company B, paying EUR 1M LIBOR +75-basis points and receiving a 7.0% fixed rate, company A secures 50-basis points of profit and reduces its interest rate exposure.

In part 4 of 10 of this series, we’ll discuss floating-for-floating and fixed-for-fixed swaps.

Hedgebook commences SSAE 16 (SAS 70) audit with Grant Thornton.

We are pleased to report that, as part of our ongoing commitment to best-practice, and to provide further assurance to our customers of the integrity of our systems, processes and data, we have engaged Grant Thornton to conduct a SSAE 16 audit of Hedgebook.

SAS70

Previously known as SAS 70, SSAE 16 is a widely recognized auditing standard developed by the American Institute of Certified Public Accountants (AICPA) that represents that a service organization has been through an in-depth audit of their control objectives and control activities. In the case of Hedgebook, this audit will focus on our IT infrastructure and the processes in place that ensure service levels are maintained and that data integrity and security is guaranteed.

Hedgebook recognizes that in today’s global economy, service organizations and service providers must demonstrate that adequate controls and safeguards are in place, particularly when hosting or processing data belonging to our customers.

Grant Thornton’s audit process is being conducted by Hamish Bowen, National Director, IT Audit & Advisory. This audit process has commenced and the first phase is expected to be complete in November.

For more information on SSAE 16/SAS 70 please visit here

The differences between Currency Swaps and Interest Rate Swaps

This is part 2 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 1, we discussed the beginnings of swaps. In part 2, we’ll explore the differences between the two major types of swaps and their different uses for financial institutions.

There are two main types of interest rate swaps, currency swaps and interest rate swaps. Although there are many other variations – including the more recently popular commodity swaps and credit default swaps – this series will concentrate on the main two types. Since 1981, the swaps market has grown into the largest financial derivatives market in the world, with trillions of funds in use today.

Broadly speaking, a swap is a financial derivative in which two parties (called counterparties) exchange future cash flows of the first party’s financial instrument for the future cash flows of the second party’s financial instruments. The most common type of swap is a plain vanilla swap, or an interest rate swap, and is when one party exchanges its fixed rate obligation with a second party’s floating rate obligation. Why would two parties want to exchange future cash flow obligations?

Typically, swaps occur when the two parties have differing interest rate forecasts. For example, if the party holding the floating rate instrument believes rates will increase in the short-term while the party holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations.

Let’s be clear – both parties are seeking a comparative advantage, hence the desire to swap obligations. When borrowing money, a party wants to seek the lowest possible borrowing rate in order to reduce future payments. In some conditions – like those experienced by the World Bank in 1981 – a party does not always find itself borrowing in its desired environment, i.e., when it seeks to borrow at a floating rate but can only finance at a fixed rate. In parts 3 and 4, we’ll dive into specific examples of interest rate swaps and how they’re calculated.

Currency swaps differ slightly from plain vanilla swaps or interest rate swaps. A currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the U.S. Dollar) for principal interest and fixed interest in another currency (i.e. the Euro). Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Hedging against exchange rate risks is vital to companies in the global market. For example, if a U.S. company is selling products in Germany, it receives payments for those goods in Euros. If the value of the Euro plummets while those goods are being sold, then it loses potential profit. To hedge against this type of risk, that company might sell Euro futures. That way, any value that the Euro loses that could hurt revenue is insulated by the offsetting position in the futures market.

The purpose of currency swaps is similar to that of futures: to limit risk from international financial transactions. The HedgeBook Blog recently discussed interest rate swaps and their basic functions in the recent blog post, “Just What is an Interest Rate Swap?”

In parts 3 and 4 of this series, we’ll discuss the differences between the common fixed-for-floating swaps and less common but still prevalent floating-for-floating and fixed-for-fixed swaps. Bring your calculator!

Why Are Interest Rate Swaps Important?: A Brief History

This is part 1 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In part 1, we discuss the history of interest rate swaps so as to better understand the vital importance of this investment vehicle.

What is an interest rate swap? We first must go back to 1981 to see their first application. In 1981, IBM and the World Bank made the first swap, a currency transaction. But why? The World Bank borrows money to lend funds to developing countries for mainly construction projects. In essence, similar to how commercial banks like Bank of America lend to small business, the World Bank lends to developing nations.

But the World Bank was in a bit of a conundrum: interest rates were sky high (at least compared to today’s levels), with the Federal Funds rate at 17%, the Swiss key rate at 8%, and the West German key rate at 12%. Similarly, per laws in both countries, the World Bank had reached its borrowing cap in Switzerland and West Germany.

At the same time, IBM held a large amount of debt priced in Swiss Francs and German Marks. To help one another out, the World Bank borrowed $290 million in U.S. markets and swapped those U.S. Dollar obligations in exchange for taking on IBM’s Swiss Franc and German Mark obligations; swaps were born.

Today, the swaps market is extremely liquid with hundreds of trillions of dollars worth of swaps in existence (according to the Bank of International Settlements, the swaps market totaled $415.2 trillion – almost 9 times global GDP!) in an over-the-counter (OTC) market (OTC means there is no centralized exchange). There are two main types of swaps, plain vanilla or interest rate swaps, and currency swaps. Other common swaps are commodity swaps and credit default swaps, but the majority of this series will concentrate on the two main types, as they comprise a majority of transactions in the deepest financial derivatives class in the world.

In part 2 of 10 of this series, we’ll explore the differences between the two major types of swaps – currency swaps and interest rate swaps – and their different uses for financial institutions, large or small.