What are currency swaps and interest rate swaps?

What are currency swaps and interest rate swaps?

Interest rate swaps involve exchanging cash flows generated from two different interest rates—for example, fixed vs. floating. Currency swaps involve exchanging cash flows generated from two different currencies to hedge against exchange rate fluctuations.

What is currency swap and how it works?

A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

How does a cross-currency interest rate swap work?

In a cross-currency swap, interest payments and principal in one currency are exchanged for principal and interest payments in a different currency. Interest payments are exchanged at fixed intervals during the life of the agreement.

Who benefits from a currency swap?

Currency swap allows a customer to re-denominate a loan from one currency to another. ADVERTISEMENTS: The re-denomination from one currency to another currency is done to lower the borrowing cost for debt and to hedge exchange risk.

What are the risks in currency swaps?

Risk of Cross Currency Swap If the counterparty to the swap fails to meet their payments, the party cannot pay their loan. Such a risk is mitigated through cross currency swaps with a swap bank present, which can thoroughly assess party creditworthiness and their ability to meet their obligations.

What are the disadvantages of currency swap?

Disadvantages

• Since any of the one party or both of the parties can default on the payment of interest or the principal amount, the currency swaps are exposed to the credit risk.
• There is a risk of the intervention of the central government in exchange markets.

What is interest rate swap in simple words?

An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.

What is the purpose of interest rate swap?

Interest rate swaps can exchange fixed or floating rates in order to reduce or increase exposure to fluctuations in interest rates. Interest rate swaps are sometimes called plain vanilla swaps, since they were the original and often the simplest such swap instruments.

What are the advantages and disadvantages of currency swap?

In the longer term, where there is increased risk, the swap might be cost effective in comparison with other types of derivative. A disadvantage is that, in any such arrangement, there is a risk that the other party to the contract might default on the arrangement.

What is the advantage of interest rate swap?

What are the benefits of interest rate swaps for borrowers? Swaps give the borrower flexibility – Separating the borrower’s funding source from the interest rate risk allows the borrower to secure funding to meet its needs and gives the borrower the ability to create a swap structure to meet its specific goals.

Why do companies use interest rate swaps?

Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt.

Are currency swaps legal?

In finance, a currency swap, also known as cross-currency swap, is a legal contract between two parties to exchange two currencies at a later date, but at a predetermined exchange rate.

What is the purpose of interest rate swaps?

What are the risks of interest rate swaps?

What are the risks. Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk. Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk.