© 2000 John Petroff
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© 2000 John Petroff |
Swaps is a general term indicating a replacement of one liability or claim by a similar one, somewhat similar to the refunding process just described. But the difference is that swaps can be arranged with much less formality and much greater speed and ease. Many financial institutions, intermediary and other corporations can be ready and eager to act as counter-party to some of the possible swaps. There are many different types of swaps: interest, maturity, currency.
An interest swap consists in exchanging a fixed interest rate obligation for an equivalent obligation with a variable rate, or visa versa. Such a transaction is justified by the terms on the assets of the company. For instance, a firm has sold its inventory for notes receivable with an indexed interest rate, whereas its own notes payable are fixed rate and a drop in interest rates is anticipated, then exchanging the fixed rate notes for indexed notes would avoid potential increased exposure in interest expenses. Note that the swaps can pertain to the interest payment only and not the principal: company A will pay the variable rate when it is due on behalf of company B, and company B will pay the fixed rate on behalf of company A.
A maturity swap for most firms is in the direction of lengthening the maturity of current obligations, because cash flows from assets are most often continuously delayed. For instance, a company purchases large inventory shipments with trade notes. It will have to pay the notes within 30 to 90 days, but the inventory may not be sold for a year or two. To solve the exposure, the company can exchange the trade notes for an intermediate note. In this case, there will be a charge for the swap.
A currency swap is normally practiced in international trade. For instance an American company A has sold a shipment of airplanes to a Japanese importer and has a claim for the Yen equivalent of 100 million dollars to be collected in six months. Over the coming six months the exchange rate of Yen for dollars is likely to change. This means company A has a currency exposure. To reduce of eliminate this exposure, it can find an American importer B who will have to pay the Yen equivalent of 100 million dollars in the future. The two American companies can swap: company A promises to pay the Yen equivalent of $100 million in six months to company B, and company B promises to pay 100 million dollars in six months to company A. Both companies have now eliminated their exposure. It is usually not possible to find a perfect match, but there are specialized brokers that can help achieve a significant exposure reduction.
See review questions Q-12G3.1 through Q-12G3.4.
See research assignment R-12G3.1.
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