Page 151 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes 4. Can be applied to either new or existing borrowings.
5. They are off-balance sheet instrument.
6. On each interest payment date only the net interest differential is paid/received by
counterparties on each interest payment date.
7. The frequency of payment reflects the tenor of the floating rate index.
8. Involves exchange of interest obligations between two parties at regular intervals over
the life of IRS.

Advantages of IRS

The advantages of IRS are given below:
1. To obtain lower cost funding.
2. To hedge interest rate exposure.
3. To obtain higher yielding investment assets.

4. To create types of investment assets not otherwise obtainable.
5. To implement overall asset or liability management strategies.
6. To take speculative positions in relation to future movements in interest rates.

7. They are used to hedge interest rate risks as well as to take on interest rate risks.
8. They are a versatile financial tool used in global financial markets. IRS provides flexibility
in asset and liability management and allows banks and companies to convert assets and
liabilities from one interest rate basis to another.
9. IRS can be used as a cost – cutting device, while leaving the underlying source of funds
unaffected. Treasurers can use the interest rate swap market to manage existing liabilities
as well as swap off a new issue.
10. Help counterparties to take advantage of current or expected future market conditions.
11. Corporations employ interest rate swaps to dynamically change their financing structure
from floating rate exposure to fixed, and vice versa.
12. Swaps can also more precisely match financing risks with operational risks.
13. Swaps can be used to lengthen or shorten the average maturity of a portfolio or liability
structure.

9.4.2 Plain Vanilla Interest Rate Swaps

The most often used interest rate swap is called the ‘plain vanilla swap’. Plain vanilla swaps are
typically an exchange of floating rate interest obligations for fixed rate interest obligations. The
plain vanilla swap involves an agreement between parties to exchange periodic payments
calculated on the basis of a specified coupon rate and a mutually agreed notional principal
amount. The counterparties in the swap are the payer and the receiver of the fixed rate.
Thus, a plain vanilla swap is an agreement between two parties in which each contracts to make
payments to the other on particular dates in the future till a specified termination date. One
party, known as the fixed rate payer, makes fixed payments all of which are determined at the
outset. The other party known as the floating rate payer will make payments the size of which
depends upon the future evolution of a specified interest rate index (such as the 6 month LIBOR).

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