Page 152 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 9: Interest Rate and Currency Swaps

Figure 9.3 gives an example of a plain vanilla swap. The principal is $15 million and the life of Notes
the swap is 6 years. The two counterparties in this swap deal are counterparty A and counterparty
B. Counterparty A has borrowed funds in the floating rate market but wants to pay interest at a
fixed rate. On the other hand, counterparty B has borrowed funds in the fixed rate market, but
when he sees interest rate declining, he decides to swap some of this fixed rate borrowings for
floating rate. Hence, in the above example counterparty A is the fixed rate payer while counterparty
B is the fixed rate receiver. An interest rate swap in the above deal helps in transforming one
type of interest rate obligations into another enabling the participants to adjust their interest
rate obligations.
Figure 9.3: A Generic/Plain Vanilla Swap: $15 million, 6 Years

Also, no payments corresponding to the principal amounts are involved in the transaction. The
only exchange that is made is interest payments on the principal.

9.4.3 Types of Interest Rate Swaps

Different types of interest rate swaps are discussed below:

1. Basis Swap: A swap in which a stream of floating interest rates are exchanged for another
stream of floating interest rates, is known as basis swap.
2. Forward Swaps: Forward swaps are those swaps in which the commencement date is set
at a future date. Thus, it is possible to lock the swap rates and use them later as and when
needed. Forward swaps are also known as deferred swaps (different from deferred rare
swaps) as the start date of the swap is delayed.
3. Putable Swaps: A putable swap gives the seller of the swap (the floating rate payer) the
chance to terminate the swap at any time before its maturity. If the interest rates rise, the
floating rate payer will terminate the swap.
4. Rate Capped Swaps: An interest rate swap, which incorporates the cap feature, is called a
rate capped swap. If a floating rate Payer anticipates a rise in interest rates then he can
purchase a cap at a free payable up front to the fixed rate payer so that the floating payable
cannot exceed the capped rate.
5. Deferred Rate Swaps: A differed rate swap allows the fixed-rate payer to enter into a swap
at any time up to a specified future date. In the swap the fixed rate payer can defer the
payment until a time when the rates are lower so that he ends up paying less than what
would have been paid, at the rate on the commencement date.

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