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Interest Rate Swaps And Foreign Currency Swaps

Abstract

This paper seeks to explain how interest rate swaps and foreign currency swaps can be used to manage risk. The extensive volatility of the financial markets has resulted to a sudden rise in the increased financial price risks that companies are facing at the present moment. This has therefore resulted to companies being exposed to certain risks that are caused by unanticipated movements in exchange rates and the interest rates. With the rise in the global telecommunication industry, companies associated to this industry are being exposed to a wide range of financial risks, more precisely, foreign exchange risks and the interest rate risks. The management of these risks has become a dominant aspect for companies to remain volatile in the present financial market.

Introduction

Over the past decades, the financial markets have become so volatile due to the essential changes that are approved in both the domestic and the global financial market. There is need to implement changes in financial markets when a country is experiencing some state of insecurity or it is under political instability. As it can be recalled during the post war period in the United Kingdom, corporations were in fear about market fluctuations which would unexpectedly hit on the foreign exchange rates and the interest rates. The fear was propagated by the fact that by then the interest rates were rather stable and the fixed exchange rates in the U.K provided companies with adequate information concerning the exact amount of home currency that was required to cater for the imports (Grant and Marshall, 1997).

In today’s business world, there is some uncertainty about the prevalence of monetary risks and interest rate risks. With the unrelenting unevenness of these risks, businesses, whether on international or domestic status are cautious about the impact that such factors can bring into the business. They are even very certain and careful about the gains and loses that such unexpected movements can cause to the business if they are left unmanaged. Exchange rates risks therefore predispose businesses into a variety of risks, which are frequently multifaceted and some other times hidden and thus, alter the worth of the foreign assets and liabilities that are on hand. On the other hand, the interest rates will change the capital value of the firm as it can ultimately affect the competitive aspect of the company, thus affecting the volume of the future cash flows. This will also have a profound effect on the firms’ assortment, as the interest rates movement will affect the investment pattern of the firm via its effects on the total value of the capital.

Financial Derivatives

In this regard, multinational corporations together with the domestic firms ought to manage such risks since failure to handle them in due time would result to total failure of the business. With the adequate knowledge about the existence of these risks in the financial and the competitive environment in numerous corporations, increased centralization of the economic activities, the record on the global currency and interest rate instability, recent inventive foreign and interest rate risks prevarication techniques have swiftly evolved rapidly (Kuper, 2005).

They are therefore designed to equip the management with relevant measures that can be used to control risks and lessen the effects of doubtful cash flows. To manage and curtail such unprecedented risks, the financial institutions are therefore on the move in providing companies with a range of derivatives that assists in the management of risks. The table below provides some of the instruments that are very pivotal in the management of risks. Other financial derivatives that are not included in the table, but forms some of the foreign exchange instruments used in the management of risks include Options and Interest rate forwards called “forward rate agreements” (Abken, 1993).

Financial Derivatives Instrument Year of Introduction
Foreign Exchange Instrument
Foreign exchange futures
1972
Currency swaps 1981
Forward Contracts on foreign exchange 1972
Interest rateinstruments
Interest rate swaps 1982
Interest rate options 1982

Table 1: Financial derivatives instruments

Forward contracts comprise the oldest instruments that are used to manage risks. Such instruments can be used to manage both the interest rate and foreign exchange rate. A forward rate agreement means a forward contract on the interest rates. As much as forward contracts can be used to manage financial risks, future contracts also forms better instruments that can be used to manage the risks – both foreign exchange risks and the interest rate risks. In addition, the swap contracts have been identified to form the latest innovative measure that can be used to manage finances (Arak, et al, 1988).

The swap contract was set up in 1981 after the IBM and the World Bank entered into an agreement on the use of the currency swap transaction in a bid to compare their mutual advantage in the alliance: a detailed example of a swap process is elaborated in the next section. A swap contract coerces two parties to have a particular exchange in cash flows at particular intervals. In essence, a swap contract can be explained as a sequence of forward contracts that are merged together. A currency swap contract will then comprise the exchange of interest rate payments in a given currency for a consideration (payment) in another currency (Soenen and Madura, 1991).

The most common form of currency swap is the interest rate swap. This form of currency swap involves an agreeable exchange between parties having a common interest in a similar currency, on an agreed principal amount of time on a given period of time. To be more precise, an interest rate swap is an accord that is generated between two parties to exchange interest payments evaluated on different platforms over a specified period of time. The very common form used in this case involves one party making fixed payments while the other party making its payment based on the floating rate (Collier and Davies, 1985).

Interest rate swaps are preferred in management of the risks since they provide the company with added flexibility in being able to make use of the comparative advantage in their particular financial markets. According to Glaum (1990), the interest rate also allows businesses to focus and stress on the importance of enhancing comparative advantage in borrowing in a single currency “in the short end of the maturity spectrum vs. the long-end of the maturity spectrum”. Moreover, currency swaps allows companies to utilize the advantages over a matrix of currencies and maturities. In light of this, the following case study best explains how the foreign exchange rates and interest rates swap aids in the management of financial risks.

The Case of U.K Telecommunication Industry

The U.K Communication sector is a firm that is characterized by a tiny layer of larger firms and at the same time featured by a bigger layer of smaller firms that do supply the sector with much of the innovation required. As the technology changes, the telecommunication sector is also swiftly becoming a multinational aspect. Globalization of this sector has also triggered a merger over the related sectors. For instance, its rapid growth on an international scale has resulted in the amalgamation of information technology sectors; the broadcasting technologies among other market related aspects. The pace at which globalization of this sectors is growing is set to increase as much as there is liberalization of the EU and the global telecommunication markets (Grant and Marshall, 1997).

Similarly, the U.K market is at the verge of being competitive in the field, with BT and Cable and Wireless being the most successful. In the field of mobile telecommunication, the U.K Vodafone is performing exemplary. With the ever-growing telecommunication service in a global aspect, the companies within this industry are being exposed to diverse financial risks. More precisely, the risks that the telecommunication sector is experiencing are the foreign exchange risks and the interest rate risk. If these risks are left exposed, they may end up causing chaos and financial problems for the industry.

In this regard, a derivative such as interest rate swaps is applied in the alliance between two firms. For instance, Vodafone uses interest rate swaps and other derivatives to manage financial risks. Let us say, in December 31, 2010 there was a ‘plain vanilla” swap between Vodafone and a non-governmental institution (Company B), which should last for 5 years. Vodafone decided to pay B a fixed rate of interest (6%) on an imaginary principle of ₤20 million, and B decided to pay on a floating rate to Vodafone a sum equivalent to one-year LIBOR + 2.5% per year on an imaginary principal of ₤20 million. It is assumed that the two organizations swap payments yearly on December 31, from 2011 to 2015.

Therefore, in December 31, 2010, Vodafone will pay company B ₤20 million * 6% = ₤1.2 million. On December 31, 2010, one-year LIBOR was 0.786%; thus, Company B will pay Vodafone ₤20 million * (0.786% + 2.5%) = ₤657200. Swap contracts allow payments to cancel each other. Here, Vodafone will pay ($1,200,000 – ₤657200 = ₤542800), and Company B pays nothing. In essence, Vodafone is able to value its comparative advantage in the lending market, thus applying appropriate measures to avoid risks. The figure below depicts this scenario, which occurs yearly.

Interest Rate Swap
Figure 1: Interest Rate Swap

From the case, there is a need to first establish the management objectives that directly deals with the risk in determining how the risks ought to be managed. A risk within a business enterprise should not be cordoned, but should be embraced because it will help the business in identifying its financial loopholes. It is also a test for entrepreneurs and managers whether they are vigilant of whatever is happening within the business. What matters in this case, is the nature of the risks identified and the way it should be handled considering the culture in which the company upholds in dealing with risks.

Therefore, the culture which the business uses in managing risks is very essential and ought to be established at the very first stage. For the foreign currency swaps and interests rates swaps to be effective in managing financial risks, a management program is required, which should have well stipulated objectives with visibly stated guidelines, and authority limits for managing risks.

According to Smith and Stultz (1985), hedging practices in use within organizations do vary from one company to the other, with the decision to prevaricate being founded on the attitude that the management has on various risks. The attitude upheld by the management team can vary from being disinclined to being a risk-taker. Companies that are reluctant to control risks seek to cover every loophole that emerges, while as the risk-takers leaves all the loopholes un-hedged with the belief that such risks will be counter set by the movements that occur from the foreign exchange or the interest rates. If the company is risk-disinclined, then the capital function will be organized as a cost center while if it is a risk-taker the capital function will be perceived as a profit center (Mian, 1996). However, in most cases, companies do not assume either of the attitudes. In such a situation managers are compelled to assume an acceptable limit in managing the risks rather than doing away with all the risks that may emerge. Therefore, foreign exchange swaps and interest rate swaps become the better option in managing the risks.

Interest Rate Swaps

Interest rate swaps is the most and widely used measurement in management of risks. It falls under the category of interest rate derivative. As explained in the beginning of this discussion, an interest rate swap is defined as an agreement that subsist between two parties – in which each party is obliged to make a sequence of payments to the other party. The payments made in this case are done at predestined rates at diverse rates. The main type of interest rate swap used in managing risks in most cases is the plain Vanilla swap.

Such a swap occurs where one part of the payment is fixed while the other part is floating. This is the only known type of interest rate swap that forms the largest single financial derivative market in the global world. The two parties that enter into the agreement are triggered by diverse motivations in entering into the contract. An outstanding corporate body with a good history as a borrower may anticipate that the interest rates are on move to rising, and they therefore opt to enter into a swap agreement (Soenen and Madura, 1991).

In this agreement, the corporate body will be at the best position of being able to pay up the fixed rate, and on the other hand receive floating interest rates. This will put the treasury on a better platform in protecting the firms from upcoming debt-service payments. Most firms will therefore go for this option – the interest rate swap – as it will help in managing the payment schedule of their liabilities. Some firms that might not be favored by this option, as they may be holding interest sensitive assets, may use swap to modify the structure of the cash inflows. Another reason why swap contracts may be favored in management of risks is that mostly there is less paperwork, non-bureaucratic and minimal costs. This is in comparison to other derivative instruments (Soenen and Madura, 1991).

Foreign Exchange Derivatives

There are numerous derivative instruments as indicated by Table 1 in this discussion. All these derivatives are used by the company in managing the exposures that the company may be subjected to. The exposures in this case may involve the foreign exchange risks, such as forward contract, future contract, future contracts, swaps and the options. Foreign exchange swaps are also utilized as instrument on the management of foreign exchange risks. After their set up in an international scale, foreign exchange swaps have proven to be one of the largest financial derivative markets in the global market (Kohn, 1990).

Foreign Exchange Swaps

Foreign exchange swaps may be defined as a contract between two parties, through which there is an agreement that involves principles and interest payments over a given period of time within an agreed exchange rate. Companies that perform their businesses by using one currency would be compelled to use foreign exchange swaps if there is need to borrow. Foreign exchange swap is effective in management of the risks because it is cost effective when a company borrows using its own currency (Duangpoly, Bakay, and Belk, 1997). This is because the borrowed funds will be received up-front and both the interest and the principal are made using the same currency. When the interest and the principal amounts are received in its own currency, this would mean that the company would be in a better position to completely or partially offset its debts. This will enhance the company to receive funds up-front and make other payments using other desired currencies (Choi & Elyasiani, 1999).

Additionally, foreign exchange swaps would help in the management of risks considering that each contracting party in the agreement is enabled to borrow from the market that it posses a comparative advantage (Khoury and Chan, 1988). This means that the parties in the contract gain an advantage from the swaps because costs of borrowing are greatly reduced.

Another factor which makes them to be favored in management of risks is that they allow companies to modify liabilities. Lastly, they may be favored in management of risks since they can be conferred for a wide range of maturities for up to at least a decade and can be perceived as a sequence of forward contracts between the two parties (Jesswein, Chuck, and William, 1995).

Conclusion

The use of derivatives to prevaricate the financial price risks of financial exchange exposure and the interest rate exposure is an aspect that is well propagated among numerous companies on an international scale. Most particularly, the financial management of risks using the interest rate swaps and the foreign exchange swaps has been predominantly in use in the U.K. With more than 50% of the global large companies reporting that they at least use these derivatives, U.K smaller companies have overlooked the use of these derivatives in managing the financial risks. However, as discussed throughout this paper, both the foreign exchange swaps and the interest rate swaps have indicated to be appropriate parameters in management of financial risks. They became effective when they are well programmed and used in alignment with clear guidelines and well defined policies.

Bibliography

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