Swaps
Doing business overseas requires a number of strategies to manage foreign exchange rate risk. One of those techniques is the interest rate swap. A swap can also be used for domestic transactions as well. An interest rate swap is "an agreement between two parties to exchange one stream of interest payments for another, over a set period of time." There are several types of swaps. The main type is the plain vanilla swap. This type of swap consists of a fixed rate payment being exchanged for a floating rate payment. The two counterparties must come to an agreement over the rates to be paid. The counterparties are usually a corporate customer and a bank that acts as the market maker (Johnson, 2011). The counterparties typically engage in swaps to lower their risk (Loeys, 1985).
Swap pricing also tends to reflect comparative advantage. If a counterparty received no advantage from the swap, then the counterparty would have no incentive to engage in the swap. Thus, swaps are often conducted by counterparties where one has a pricing advantage in fixed interest rates and the other has a pricing advantage in floating rates.
Swaps have been adapted a foreign exchange hedging vehicle as well. This is because the expected change in the value of foreign currencies reflects expectations of the differential interest rates in those two countries. This is the condition known as interest rate parity. However, swaps can earn investors or corporations an opportunity to lower borrowing costs. This works because a company can have better credit in one country than in another. The counterparty might have the same situation with the countries reversed. This would create an opportunity for a swap, because the first company could borrow relatively cheaply in its home currency and the same would be the case for the counterparty.
While swaps are used to reduce risk, they also introduce risk. As Duffie and Singleton (1997) note, swaps contain default risk. Each counterparty...
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