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Swaps Explained: Interest and Currency

The original motivation for the participation in an interest rate swap was for the two parties to reduce their borrowing costs. This was achieved by both parties borrowing in the market which they has a comparative advantage in their cost of borrowing. They would then swap their interest rate commitments at a rate beneficial to both parties and for a specified period. However, as international markets became more integrated and informationally more efficient, scope for the arbitraging interest rate differentials between borrowers in different markets reduced significantly. Rather than the interest rate swap market diminishing in response to the reduced opportunities, the swap technique was adapted to serve other purposes. Important among the other uses of swaps is that of managing existing interest rate exposures. A party with a fixed interest commitment, for example can use a swap to create a synthetic floating rate liability.

Currency swaps may be used when an interest rate swap involves the borrowers deriving their funds in different currencies. When a currency swap is undertaken, unlike an interest rate swap, the principal amounts raised by the two borrowers are swapped at the commencement of the agreement and are re-exchanged at the end of the agreement. With the decline in interest rate arbitrage swap, the currency swap techniques have also been used for a variety of other purposes, including the management of FX risk.

Swaps are usually arranged by financial intermediaries. While the counterparties to the swap continue to meet their obligations under the agreement, the intermediary in a matched swap is immune from interest rate and exchange rate risk. However, if one party defaults in its payments, the intermediary no longer has a matched swap and the intermediary is exposed to risk. Partly because of the risk of the counterparty default, and because of the very large notional principal commitments of banks under intermediated swaps, the bank capital adequacy guidelines apply to swaps. The guidelines require the conversion of a swap’s notional principal to a credit-equivalent amount. An exposure weighting is then applied to calculate the amount of capital that must be held in support of the current and potential exposures of the swap.