The following points highlight the four main categories of swaps between corporate borrowers. The categories are: 1. Principal-Only-Swaps 2. Interest Rate Swaps 3. Currency Swaps 4. Carry Trade Swap.
Category # 1. Principal-Only-Swaps:
These are typically used for hedging loan transactions. If a corporate borrowers in Yen and wants to swap the loan into US$ or Rupee, it could opt for a product like principal-only- swaps (POS). This helps you move the principal from one currency to another. Most companies, who have gone for external commercial borrowings (ECBs) denominated in Yen, have opted for a POS. This locks in their liability by moving the loan from Yen to Dollar, which protects them against the Dollar- Yen exchange rate movements.
Category # 2. Interest Rate Swaps:
An interest rate swap is an agreement whereby one party exchange one set of interest rate payments for another. In interest rate swaps, only interest rate part of the loan is considered. If a company takes a view that the interest rates are going to be higher and if it has borrowed in floating rate, say linked to the LIBOR, then it could do an interest rate swap – it pays a fixed rate and receives a floating rate from the bank. This effectively converts a floating rate liability into a fixed rate liability. Companies enter into interest rate swaps when they expect interest rates to move up or down.
When they expect interest rates to move up, they would do a swap by which they will receive a floating rate from the bank, and pay a fixed rate. Similarly, when they expect interest rates to fall, they would do a swap by which they will receive a fixed rate from the bank, and have to pay a floating rate. Most common arrangement is an exchange of fixed interest rate payment for another rate over a time period. The interest rates are calculated on notional values of principals.
Category # 3. Currency Swaps:
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The currency swaps are arrangements whereby currencies are exchanged at a specified exchange rates and specified intervals. The currency swap is a derivative instrument which takes care of both, principal-only-swap and interest rate swap, together. If a company has borrowed in US $ and wants to convert it into a Rupee loan, it can do a currency swap, wherein it will receive from the bank the principal and interest in US $, and pay the bank a fixed Rupee interest rate and also freeze its principal payment for the entire tenure of the loan. Effectively, the Dollar loan becomes a Rupee loan in Indian rupees.
Category # 4. Carry Trade Swap:
In a carry trade swap, a company can move from a higher interest rate currency to a lower interest rate currency and rather than hedging the full currency risk through forward contract which would eliminate the carry, it can reduce the cost of hedging by buying options with a knock-out (an option which ceases to exist if a knock-out event happens and a particular level is hit-like Yen hitting a particular level against the Dollar).
As long as the knock-out doesn’t happen, then the company has to buy the Swiss franc/Yen at the market rate prevailing on the date of maturity and settle the deal on maturity and hence will get exposed to the currency fluctuation between the US dollar and Swiss franc or between the US dollar and Japanese yen. Banks use various permutations and combinations to structure products and create a payoff (risk-reward equation) that a client is comfortable.