Swap: Is where two companies agree to pay each others interest payment. THis maybe in the same currency ( an interest rate swap) or differenct currencies( a currency swap)

Currency swap

A UKcompany is intending to invest in the US and will therfore be earning income in $, They need to borrow money for the investment and have decided to borrow $

Another company in the USis intending to invest in the UKand for the same reasons as above they wish to borrow F

The UKcompany borrows F and the us company borrows an equivalent amount of $. The two parties the swap funds at the current spot rate. 

UK pay inyrtrdy on yhr $ loan, US company pays the F interest 

Ad:

Flexible: can be arranged in any size and reversed if necessary

Costs lower: without intermediary , no premium need to pay

Market abvoidance: reduce uncertainty to foreign exchange market 

Access to finance and lwer interest rate

Financial resturcturing

Dis:

Default risk

Sovereign risk

Arrangement fees

Forex swap, it is a spot currency transaction coupled with an agreement that it will ne reversed at a pre-specifined date by an offsetting froward transactions

Interest rate swap: is an agreement whereby two companies, or a company or a bank , swap interest rate (same currency)commitments with each other.

Manage interest rate risk, Reduce borrowing cost , a bank will orgazise the swap

Step1, fund the comparative advantage

Step2, compare co-operate and not co-operate-benefit

Step3, share benefit and fee

Step4, swap results

before swap    

Less: net benefit of swap

Actual costs

Step5, swap process

borrowed at @

swap:

 A pay B 

B pay A

fees

Effective interest rate

Advantage of swaps: over-counter arrangement. they can be arranged in any size. it gives a better resuplt if base rate rises by 

Forward rate agreement : A contract with a bank to receive or pay an interest at a determined interest rate on a notional amount over a fixed period in the future.

Over the counter agreement

Interest rate future: An agreement with an exchange to pay or receive interest at a pre-determined rate on a notional amount over a fixed standard period in the future.

--Contract to buy: Companies that will have a cash flow surplus require contracts to buy

--Contract to sell: companies that will borrow require contracts to sell.

 will be worried about interest rates rising. this require a futures contract to pay interest

Future to hedge: 

Step1: Now: buying or selling interest, choosing the closest standardise futures date aft erthe loan begins

Step2: In the future:complete the actual transaction on the spot market

Step3: At the same time as Step2: Close out the future contract by doing the opposite of what you did in Step1

Exchange-traded interest rate options: An agreement with an exchange to pay or receive interest at a pre-determined rate on a Standard national amount over a fixed standard period 

--Put option; an option to pay interest, a right to sell

--Call option: an option to recieve interest, a right to buy

Step1: Now call or put option, pay premium for the option

Step2: In the future:complete the actual transaction on the spot market

Step3: At the same time of Step2

 Close out hte option contract on the futurem market

 Collar : a company can write and sell options to raise revenue to reduce the expense of an exchange traded interest rate options. A combined strategy of buying and selling options is called a collar

--For a borrower: a collar will involve buying a put option to cap the cost of borrowing and selling a call option at a lower rate to establish a floor.

     If the interest rate rise the borrower is protected by the cap

     IF the interest rate falls the borrower will benefit until the interest rate falls to the level of the floor

--For a invester: a collor  will involve buying a call option to establish a floor for the interest rate and selling a put option at a higher rate to establish a cap

      if interest rates fall the investor is protected by the floor

       If interest rates rise the investor will benefit until the interest rate wises to the level of the caps

OTC collar: using the combination of cap and floor simultaneously to redcue costs:

interest rate cap

is an option which sets an interest rate ceiling

Interest rate floor

Is an option which sets a lwer limit to interest rate

Set up the hedge: Step 1: buy (floor or cap) and sell (floor or cap)

Step2: cash flow budget

exchange traded collar

Using combintaion of call option and put option to reduce the prmium paid

Set up the  hedge

Step1; suy x option snf drll x option

Step2: which option contract to buy or to sell

It is normal to choose the first contract to expire after the loan is required or deposit is made

Step3: no of contracts 

Step4: cash flow budget