question archive There are many different financial means that companies can utilize in order to reduce financial waste and remain lean
There are many different financial means that companies can utilize in order to reduce financial waste and remain lean
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There are many different financial means that companies can utilize in order to reduce financial waste and remain lean. One of these means would be interest rate swaps. The principle is one based on comparative advantage, in order for active liability management and hedging against interest rates. Bicksler, J., & Chen, A. H. (2012, April 30) This agreement between two companies allows them to manage their risk and operate on an interest rate that is ideal for their operations. This could be simply variable payments into fixed payments. All swaps are based on one central principle: one participant exchanging an advantage in one credit market advantage available to another participant in a different credit market Balsam, S., & Kim, S. (2001, October 30). One of the companies can be experiencing decreased cash flow and be entering the agreement in order to aid in this situation.
Two companies enter an interest rate swap agreement with a certain value in mind, one company is under the assumption that interests will likely rise in the short run and looks to profit. While the second company in play is receiving a floating interest rate return and does not share the same analysis when it comes to the outlook of interest rates in the short run. The two companies enter an agreement to profit based off of movement of the market with interest rates.
A notable risk of interest rate swaps would be counterparty risks, the two parties typically involved are larger companies or institutions the risk is relatively low. The companies for the most part are able to meet their obligations under their agreement. The legal proceedings if one institution is unable to keep their end of the agreement could and would be a difficult legal proceeding for the companies to navigate.
2- “Interest rate swap is an agreement that one party is to swap its fixed interest rate payment for a floating interest rate payment of another party(Eiteman, pg. 229, 2021).” An interest rate swap is normally offered when a country is trying to reduce or maintain a lower interest rate that may have not been possible if they had not done the swap. Some may even swap to increase exposure to fluctuations in interest rates. When a person does an interest rate swap, they are exchanging future payments for another base on the principal amount or what they are looking for. So, think of it this way. You are trading one cash flow for another cash flow. This could be a good thing in the beginning but may turn into a bad one down the line. These swaps are considered over the counter(OTC) due to their contracts between the two-party.
There are different ways you could do the interest rate swap. For example, you can have a fixed to floating sway. If a company has an interest rate that catches the eye of the public, it could swap. If the manager believes they could get a better cash flow from a floating rate, then the business would want to do a swap. You could also have a floating to fixed swap or a float-to-float swap. It all comes down to the need of both parties and their goals. It is important to remember that even though this swap is a great tool it can also be bad in the long run.
“Provus said that basis risk on a floating-to-fixed rate swap can have potential exposure as the issuer may have a difference between the floating rate on the variable rate demand obligation bonds and the floating rate would receive it from the swap counterparty (Provus,2021).” This could happen if the floating rate bond has a Bond Market Association (BMA) that is different from the other party who may have a 60 percent or more of London Interbank Offering Rate LIBOR. You also have to remember just because you are getting rid of what may be a high rate doesn’t mean the cash flow or the interest you are exchanging is going to be better.
3-An interest rate swap or just a rate swap is an agreement between two parties to exchange a series of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promise to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the theoretical principal and the second party promises to pay to the first at the same intervals a variable amount of interest on the supposed principle calculated according to a floating-rate index (Bicksler et al., 2006). In addition, the first party in a fixed/floating rate swap that pays the fixed amount of interest is called the fixed rate payer, and the second party that pays the floating amount of interest is called the floating-rate payer (Bicksler et al., 2006).
Moreover, interest rate swap is optional to market transactions by two parties and both parties obtain economic benefits which are result of the principle of comparative advantage.
The risk associate with interest rate swaps are mainly a practice of risk management and risk mitigation (Mayhew, 2003).
- Risk management: there are several risk factors that essential to all derivative trades and some that are unique to certain trades. However general risks include but not limited to (1) termination risk: risk that the counterparty will terminate the swap in an adverse market; (2) fair value risk: risk that the market value of the trade becomes negative; (3) credit risk: risk that the counterparty will drop below acceptable rating levels, and (4) basis risk: risk that the basis for the variable payment received will not match the variable payment on the bonds (Mayhew, 2003).
- Risk mitigation: when an issuer does not have to give the counterparty the right to swap arrangement. In addition, an issuer can always terminate a swap (market values not resisting) and employ insurance to guarantee the performance of both the issuer and the counterparty (Mayhew, 2003).
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Discussion Responses
Greetings Student One
What a great post. Indeed, interest rate swaps is an intriguing approach that was connived to ensure that firms can exploit comparative advantage and in the end curb the financial waste that is associated with market fluctuations. It is crafty how most firms that tend to enter into such an agreement are always defined by different forecasts with regards to interest gains, with tone pursuing profits from the deal, while the other is in it simply for the floating interest rate return (Jermann & Yue, 2018). In my discussion, I noted that besides the counterparty risks, there also exists position or interest risk as well as credit risk. In the first segment, Baker et al., (2021) noted that position risks tend to occur as a result of fluctuations being experienced in the market rates, an aspect that sadly caused the adjustments in the value of the swap. As market interest rates fluctuate, swaps generate either losses or gains that are equivalent to the variation in the swap’s replacement cost. These losses or gains allow swaps to act as a hedge that a firm can use to minimize its risk or act as a speculative instrument that increases the overall risk of the company. The problem facing a company that enters into a swap to gain fee income becomes more complex. A dealer firm may enter into a swap agreement to hedge changes in market interest rates or to speculate in the same way as a user firm. However, the dealer firm may also enter a swap agreement to meet a client’s request even when the dealer firm doesn’t want a change in its exposure to the market interest rate (Baker et al., 2021). In such a case, the dealer firm must find a means of hedging the interest swap transaction.
Hello Student Two
Your insight particularly with regards to countries offering interest rate swap as a means of maintaining a lower interest rate was exceptional, as per the insight presented by Eiteman (2021); it was clear that different nations may also swap as a means of escalating the exposure to fluctuations. Complimentary to your discussion particularly with regards to the fixed or floating swap, I was compelled to ask if you were an entity engaging in such an arrangement, which would you prefer? Additionally, would you opt to settle for other financial instruments or simply choose interest swaps? According to Simons (1993), the most common use of interest swaps is to change fixed-rate debt essentially into floating-rate debt and to transform a floating-rate debt into fixed-rate debt. While it is possible to achieve this through other instruments, like futures, financial options, as well as forward contracts, interest rate swaps, offer benefits such as longer maturity and more flexibility. It is worth noting that the fast growth of the interest rate swaps market since its introduction has fuelled considerable debate concerning the economic rationale for such derivatives. Several observers have voiced concern regarding the growth and the size of the market, contending that swaps are a threat to the stability of financial markets. Others have argued that swaps expose banks to credit risks, especially the risk of non-performance by the counterparty.
Hi Student Three
Wow, what a detailed and highly accurate plot. It was fascinating to learn how interest rate swaps do work based on your discussion. In my research, I learned that interest rate swaps were considered a crucial instrument for hedging particularly by non-financial as well as financial corporations (Bowen, 2017). It is poignant to note that the typical usage of interest swaps was to transform floating rate debt into fixed-rate debt, as well as vice versa; and although there existed other financial instruments such as forward contracts, futures as well as financial options, most parties engaging in the trade preferred interest rate swaps due to the benefits offered, as well as flexibility and maturity aspects.
When expounding more about the risks which you discussed in your post, one aspect that I may add is that there also exists interest or position risk which tends to manifest whenever there is a fluctuation of market interest rates, an aspect that in the long run tends to cause an adjustment in the value of the swap (Baker et al., 2021). Besides this, it was interesting learning more about the termination and fair value risks which I believe were a great threat to the trade and could actually lead a participant to withdraw from the agreement or failing to honor their side of the deal.
