If we consider only the next payment, both parties might as well have entered into a fixed-rate futures contract. For the subsequent payment, another futures contract with the same terms, i.e. the same nominal and fixed amount for the variable, etc. The swap contract can therefore be considered as a number of futures contracts. In the end, there are two cash flows, one of the party that always pays a fixed interest rate on the fictitious amount, the fixed stage of the swap, the other by the party that agreed to pay the variable rate, the floating leg. The most common type of swap is an interest rate swap. Some companies may have comparative advantages in fixed-rate markets, while others have a comparative advantage over variable interest rates in the market. When companies want to borrow, they look for cheap credit, that is, the market where they have comparative advantages. However, this can lead to a company that says it is fixed if it wants to swim or without credit, if it wants to be fixed. This is where a swap comes in. A swap converts a fixed-rate loan into a variable rate loan or vice versa.
Swap contracts are financial derivatives that allow two transaction agents to exchange transaction flows”Revenue StreamsRevenue Streams are the various sources for which a company makes money by selling goods or generating services. The types of revenue an entity records on its accounts depend on the types of activities carried out by the company. See categories and examples resulting from certain underlying assets of each party. Take, for example, a U.S. company that has borrowed money from a U.S. bank (in USD) but wants to do business in the U.K. The turnover and costs of the company are in different currencies. He has to pay interest in DOLLARS while he generates income in pounds sterling. However, it is exposed to risk resulting from the fluctuation of the usd/GBP exchange rate. LIBOR or London Interbank Offer Rate is the interest rate offered by London banks on deposits of other banks on eurodollar markets. The interest rate swap market often (but not always) uses libOR as a basis for the variable rate.
For simplicity`s sake, we assume that both parties exchange payments each year on December 31, starting in 2007 and 2011. The management team finds another company, XYZ Inc., which is willing to pay ABC an annual LIBOR rate plus 1.3% on a fictitious capital of $1 million for five years. In other words, XYZ will fund ABC`s interest payments for its recent bond issue. In exchange, ABC XYZ pays a fixed annual rate of 5% for a fictitious value of $1 million for five years. ABC will benefit from the swap if interest rates rise significantly over the next five years. XYZ benefits when prices fall, stay flat or rise only gradually. 4. Use an exchange option: A swapist is an option for a swap. Purchasing a swap would allow a party to set up a potentially compensatory swap at the time of execution of the initial swap, but not to enter into it. This would reduce some of the market risks associated with Strategy 2.