Type of swaps available in the market
Pricing Forex swaps
The cost of the Forex swap is set by the interest rate differential between the two currencies being swapped. The amount of interest that could be earned during the period of the swap is used by the dealer to calculate the price of the swap.
In calculating the cost for the swap, the dealer uses the spot rate and adjusts it for the interest rate differential between the base currency and the terms currency for the number of days of the swap. This calculates the borrowing and lending rates for the currencies involved. The rates are then used in a second calculation to determine the swap points that will be added or subtracted to determine the price.
Currency and interest rate swaps
Interest rate swaps usually involve an exchange of a stream of interest payments without an exchange of principal; and currency swaps usually include an exchange and re-exchange of currency plus a stream of fixed or floating interest payments.
The currency swap gives companies a way to shift a loan from one currency to another or shift the underlying currency for an asset. A company can borrow funds in a currency different from the currency needed for its operations. The currency swap provides protection from exchange rate changes related to the loan.
Currency swaps are not as popular as interest rate swaps because interest rate swaps do not involve the exchange of principal, so the cash requirements and the amount of risk are lower. When you enter into an interest rate swap, the two parties involved in the swap agree to make periodic payments to each other for the period of time set in the swap. The principal amount on which the interest is based is called the “notional amount of principal”, but the amount of principal does not change hands.
The most common form of interest rate swap is one in which the payments are calculated by setting a fixed rate of interest to the notional principal amount, which is then exchanged for a stream of payments calculated by using a floating rate of interest. This is called a fixed-for-floating interest rate swap. If both sides of the cash flows are to be exchanged using a calculation based on floating interest rates, it’s called a money market swap.
Interest rate swaps are used by commercial banks, investment banks, insurance companies, mortgage companies, investors, trust companies, and government agencies for many different reasons, the most popular of which are as follows:
- To obtain lower-cost funding
- To hedge interest rate exposure
- To buy higher-yielding investment assets
- To obtain types of investment assets that might not otherwise be available
- To implement asset or liability management strategies
- To speculate on the future movement of interest rates