Currency and Interest Rate Swap

Business transactions occur on the international front and there are laws and regulations regarding the pricing of the long-term forward exchange contracts. It is noted that the violation of the traditionally covered interest arbitrage pricing relation has been rampant and that the activity in the international currency and interest rate swap markets offers a substantial explanation for the continued and prevalent wrong pricing. In essence, it will be clearly noted that the fixed-to-fixed currency swaps provide another form of arbitrage which can influence long-term forward exchange pricing.

This paper will discuss how the violation of the traditionally covered arbitrage pricing activity is always practiced by the international currency and the interest charge swap markets who are reported to be inappropriately placing the prices, the interest rate swap market is found to be providing some kind of arbitrages which actually affects the long term forward exchange pricing process. The application of both the currency and the interest rate swaps providing a market for the bonds and contracts in the international market will be critically analyzed and discussed in this paper.

INTRODUCTION

A swap is always defined as an agreement made between two parties with an intention of exchanging a particular good, this good may be something of money value, we find under this agreement one party is always willing to make some payments for the good while the other one intends to purchase basing on some interests that are to be gained.

In this case we find that as from the year 2000 the swaps has been reporting a number of growth this coming up as a result their outstanding amount of the swaps in the market (Price and Henderson, 2009). The growth of the swaps in the market, we find that there has also been an increment in the marketing of the long-term forward currency contracts; this includes other major currencies found in the international market. Therefore this paper will look at the importance of legal tender and interest rate swap in the determination of the long term forward exchange rates.

Statement of the Problem

Considering the economic factors, it can be noted that in 2000s national economy was actually growing at the desired economic growth rate which facilitated opening of more commercial banks in anticipation of earning normal profits by the investors. For instance, even after the worst economic depression of the years 2000 to 2002; the overall economic growth continues to thrive which witnessed the decrease in unemployment rates, little interest rates as well as declining rate of inflation (Price and Henderson, 2009). However, it should be noted that the problems experienced by the commercial banks in 2000s were either indirectly or directly related to the instabilities of banking environmental challenges of the 1990s.

For instance, in the 1990s the exchange rates floated thus leading to main currencies being volatile. Further there were several peripheral economic shocks such as changing interest rates due to inflation aspects as well as lack of clear monetary policies which led to escalating price levels; the later was mainly caused by the policies adopted and effects of oil embargoes of the 1990s. These failures engaged many organisations to engage in the long term forward exchange contracts

Aims

The aim of study is to shed more light on the issue of interest rate and currency swaps as a mode of financing in the foreign exchange market, the paper also aims at discussing the types and importance of swapping in the attaining of the organisations objectives. This will essentially facilitate the stability in the financial rates offered by the different financial organizations world wide and therefore lead to the facilitation of increased profit margins and rise in the growth rates of the world economies.

Objectives

The overall objective of this research work is to find out whether interest rate and currency swaps play a key role in achieving firm’s objectives with regards to the forex marketing in Australia. Other objectives will include; finding out the various swapping approaches to be used in organisations.

The specific objectives include the following;

To describe the operational environment of swapping as a mode of financing

To identify the drivers that lead to firms to carry out the interest rate and currency swaps

To analyze and critically evaluate the currency swapping in a forex market

Research Questions

Based on the objectives of this study research queries will include the following:

Does interest rate and currency swaps play a key function in attaining organizations goals or objectives?

What are the different ways of interest rate and currency used in the fore market?

The importance of using the currency swaps in an organisation?

How can the management evaluate the interest rate and currency swaps put in
place and rate them as effective or non effective?

What are the appropriate remedies for ensuring that a successful swapping is carried out

Benefits of conducting the research

This research will not only benefit foreign exchange market but it will be applicable to all those organizations who wish to engage in the interest rate and currency swap financing globally. It will provide focus and insight to the management on how the swapping is practiced and how it enables the organisation achieve its goals

Limitations of the study

Because this is an investigative study more time will be essential to carry out the exploration so as to find the pertinent information that will reveal the issue of interest rate and currency swaps as a key force to achieving results in an organization. Also another limitation is that of availability of funds because the study will require the researcher to reach to a wider population through interviewing many respondents.

LITERATURE REVIEW

Swaps

Swaps are regarded as a mode of financing that was formed as a result of problems that used to come hand in hand with various types of loans such as the parallel and back to back loans, this was back in the year 2000 and so on.

This swap financing carried a number of advantages such as the intermediaries are given an opening to have unmatched positions in swap financing. The swap financing has also led to the growth of the liquid markets through which we find that the quotes for the swaps are availed on a daily basis (Price and Henderson, 2009). As this goes then we find those using the swap financing are required to know to know the techniques of equivocation that exist in this type of financing. Research indicates that swap financing operates under the principle of exchanging cash flows whose values are said to be equal as at the time of implements the swap financing.

Types of Swaps

Research shows that there exist two main types of swap financing and they are the currency swap and the interest rate swap. Under the interest rate swap financing it requires that the exchange of the net cash flow under transaction should be based on the fixed and floating interest rate borrowings, through this we find that it has two borrowers whereby one borrower gives out a debt at a fixed rate and exchanging the periodic net payments with the other borrower presenting a debt on a floating rate (Price and Henderson, 2009).

On the other side a currency swap entails the exchanging of net cash flows basing on the debts provided that are dominating the market in diverse currencies, under this type we find that the exchange takes place when the values in the exchange are at the initiation and maturity stage working under the same exchange rate. When these types of swaps are combined we find that they lead to the exchanging of values in different currencies that have interest rates that are fixed or floating (Price and Henderson, 2009).

Research indicates that in a fixed to fixed currency swap is a type of swap financing that is normally agreed upon on a foreign exchange rates that are applied basing on the date of closure governing the initiation and maturity and also the time of the payment of the net interest while the fixed periodic net payments are normally achieved through negotiations between the parties, this negotiation is done basing on the differences that occur in existing varieties of currencies that are present at closure time, in this case the provisions made will actually be given the net payment as this happens to the fixed to fixed currency we find that the foreign borrowing that is full hedged does not require any counter partying the reason for this is that the process of borrowing is usually made straight into the targeted currency whereby the principals of exchange are always put in the required exchange using the available exchange rates.

After transacting then the paying of the coupons and the returning of the principals are fully protected using the forwarding market. Research indicates that the currency swap usually provides a differing series of cash flow while the fully protected currency borrowing only needs suitable forward exchange quotations.

Advantages of using the currency swaps

Elasticity

This currency swap financing allows the exploitation of the target markets that borrow by the organisations transacting. It also allows the organizations to know the result of using the matrices and maturities in the borrowing markets (Price and Henderson, 2009).

Disclosure

The currency swap financing produces the exposing of huge credits this comes up as a result of the exchanging and re-exchanging of the estimated principalities, this will therefore require an organisation to deliver the estimated principalities as the contract comes to its closure, this provides that the principalities should be exchanged at a rate that is fully fixed. This exposing occurs as the time for the transaction goes by this means that when the time for contract is longer then the exposure increases.

Pricing

The currency swap allows the organisation to calculate the price of its issues. this is always done by the following formula; this formula is used to indicate how the spotting and the forwarding relate; in this case we find that F stands for forwarding rate, S stands for spotting rate, the term currency is represented by the r1, the base currency is represented by the r2 and finally T stands for tenor which is determined by calculating appropriately by the day count convention and the following is the formula applied here

From the above discussion we find that the swapping points are always derived to by determining the difference between the forwarding and the spotting rates and the following is the formula used in the difference calculation

The following deviations are meant to calculate the differing factors between the Australian interest rate and that of the New Zealand which is reported to be fully hedged; in case of any negative deviations this will automatically indicate that the Australian rate is low as compared to that which is fully secured. The following information is used to calculate the differences that exist between the two parties;

The Australian chosen bonds are as follows: Source: http://www.allbusiness.com

3 year: 7 1/8, October 2003 (Note)

5 year: 8 7/8, July 2005 (Note)

7 year: 8 5/8, August 2007 (Note)

10 year: 8 7/8, May 2010 (Note)

The New Zealand chosen bonds are as follows:

3 year: 9.50 September 2003

5 year: 10.50 June 2005

7 year: 9.75 October 2007

10 year: 10.50 July 2010

Statistics in the table below indicate that in the first three, five and seven years the forwards almost reported a negative result as the ten year recorded was neither positive nor negative. This clearly indicates that there is a decreasing factor in the bonds as the time of maturation grows.

DATA

Data Source and Data Gathering Procedures

The information regarding the analysis of the information on the need to reduce the risks associated with the international currency and the interest rate swap markets. The research methodologies applied here included both qualitative and quantitative research techniques that involved the use of the interviews and the administration of the questionnaires. These were regarded as the best methodologies to be used because of the fact that they gave the respondents an occasion to answer about their point of view or perception on the current currency swap and how its application in the business organizations can be of great benefit in increasing the profit margins.

This study necessitated the identification of the main the methods used to reduce risks affecting the international currency and the interest rate swap markets. The researcher therefore mainly concentrated on the issues concerning the currency swap financing and how best it can be applied by organizations in there attempt to boost there profitability levels in the exchange market. The reason for choosing both open and closed questionnaires to be administered is that it will give the informants a chance to answer freely to set of questionnaires that will be administered to them during the study.

Methodology Used, Process and Statistical Technique

The facts and figures that were collected regarding the question under siege were collected using the analysis of the information from the secondary sources. The statistical methodologies used were the interviews and the questionnaires (in the collection of the information from the potential respondents). The statistical technique used was the data analysis of the profit realization of the business organizations operating on the international front. This therefore has an insinuation that the use of the samples from the various firms to make a quantifiable analysis in order to make the necessary recommendations as far as the pricing of long-term forward exchange contracts are concerned. This technique was preferred because of its effectiveness in the collection of data and generation of the ideologies of the individuals basing on their perception on the fixed-to fixed currency swaps and how they provide another form of arbitrage which can affect the long-term forward exchange pricing.

RESULTS AND FINDINGS

From this study we find that both the currency and interest rate swaps are the determining factors for the success of an organisation in terms of its profit maximisation. The graph below shows the comparison of the information in New Zealand and Australia on swapping and the foreign exchange rates. The variations and the figures are outlined basing on the interviews and the responses derived from the respondents concerning this issue with the incorporation of information from the financial and banking institutions from the duo. The information presented on the graph is an analysis of the currency rates and foreign exchange from the two states from the period range of 4 years (from 2006 to 2010).

Retrieved from: http://www.nzdmo.govt.nz/publications/data

DISCUSSION

From the analysis of the Australian market’s graph it is noted that the interest rate swaps allow parties to re-allocate their exposure to interest rate fluctuations by mainly exchanging fixed rate obligations for the floating rate obligations; in this case the states under investigation are New Zealand and Australia. For instance if Australia holds a fixed rate loan, New Zealand a variable rate loan, in a swap the former will make the payments to the latter loan and vice versa. This therefore has an insinuation that there is no change in the balance sheets of either party, because the principal, i.e. the underlying ‘notional’ amounts, stay where they were. In other words, what is called a $1 billion swap actually involves amounts much smaller than $1 billion.

In my own view therefore, it is worth noting that the problems faced by commercial banks in 2000s should shape the future of such business ventures. However from the recent trend of banking industry growth it will be prudent to deduce that commercial banks have learnt from the past occurrences and they have indeed engineered several issues in a bid to avoid such failures now and in the near future (Price and Henderson, 2009). For instance many banking institutions have understood the concept of diversification as well as they are now well equipped with risk management skills.

This implies that they have responded well to the concept of globalization which has become the key ingredient of modern business transactions. With globalization commercial banks now offer quality and a variety of products and services to its customers thus boosting there business growth. There the organisation planning to engage in the foreign exchange business are therefore advised to be keen on the type of swapping finance to used in their transactions to avoid following victims of failure in the transactions.

Reference:

Price, J & Henderson S, (2009). _Currency and Interest Rate Swaps._ Second edition

Butterworths, London.