Page 145 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes Introduction

The most striking development in international finance which has had the most significant
impact on the world’s money markets has been the introduction of the swap market in the
mid-1980s. Swap is essentially a derivative used for hedging and risk management. There are
numerous types of swaps, but interest rate swaps and currency swaps are the most commonly
used swaps. Interest rate swaps were one of the most important innovations in the financial
markets of the 1980s. They grew from virtually zero to an estimated $1 trillion worldwide. It is
rather difficult to find out a precise estimate of the total outstanding volume of swaps because
there is no centralised reporting agency that collects accurate data. The expansion in the swap
market has occurred in response to the challenging phenomena which have characterised financial
markets today – arbitrage opportunities, tax regulations, capital controls, etc., as a result of
market imperfection, need for protection against interest rate and exchange rate risk,
improvements in computer technology and increasing integration of world capital markets.
A swap is an agreement between two or more parties to exchange a set of cash flows over a
period in the future. The basic idea behind swaps is that the parties involved get access to
markets at better terms than would be available to each one of them individually. The gains
achieved by the parties are divided amongst them depending on their relative competitive
advantage.
Swaps have now integrated with all sorts of other more traditional financial arrangements.
Therefore, not only do the treasury staffs of companies have to be well versed in swaps, but the
bank officers who call on those people also have to understand how swaps can be used to help
companies accomplish their financial objectives.

Two categories of swaps have dominated the swap revolution: currency swaps and interest rate
swaps. In a currency swap, the counter parties initially exchange a principal amount in one
currency for the same amount converted to another currency at the prevailing spot rate. Interest
payments are then made in the respective currencies at interest payment dates and the principal
amounts are re-exchanged at maturity. In an interest-rate swap, the counter parties agree to
exchange interest payments based on a notional principal; no actual exchange of principal takes
place.
The market for both currency and interest rate swaps has grown substantially during the last
two decades. For instance, although the first interest rate swap appeared in 1982, the total
amount of interest rate swap outstandings increased from $ 683 billion at year end 1987 to
$309,588 billion in Dec 2007 to $356, 772 billion in June 2008.

Swaps, together with futures, options and other financial derivatives that rose to prominence
during the last two decades, have attained a certain maturity. Individually and together, they
allow yield curve and currency risks and liquidity and geographic market considerations, all to
be managed separately – and also independently of underlying cash market states.

Thus, swaps are a powerful tool propelling global capital market integration. However, the
realisation of total swap potential will require resolution by governments and judicial authorities
of tax and legal issues, plus revamping of management and accounting practices concerning risk
exposure.

9.1 Conceptual View of Swaps

The concept of the swap (both interest rate and currency swaps) has broad implications and
applications in finance. Condensed to its essence, however, its most important implication lies
in the idea that swap allows the separation of the funding aspect of financing from the structure
of the liability (i.e., whether it is a fixed or variable rate, the short-term interest reference rate it

140 LOVELY PROFESSIONAL UNIVERSITY