Swaps are a financial tool that companies use to hedge their risk and gain access to markets they do not otherwise have. They are used in a variety of settings to exchange cash flow and give each party access to different rates of return in order to hedge investments and/or gain comparative advantage.
Two major kinds of swaps are interest rate swaps and currency swaps. The difference between them is that the former does not involve swapping the principal, while the latter does.
Interest Rate Swaps
Examine the contract to find the principal amount. This will be fixed and agreed-upon. Assume for this example that it is $100.
Calculate the first company's obligation on that amount. This, too, will generally be fixed. Assume here that it is five percent, or $5.
Calculate the second company's obligation. This is usually floating. Assume that this year it is six percent, or $6.
Subtract the lower obligation from the higher obligation. In this case, the second company owes more, so we subtract $5 from $6. The second company owes $1, or one percent of the principle this year.
Ensure the principal is worth the same amount in each currency by multiplying it by the exchange rate. So, if a United States and New Zealand bank are exchanging currencies at 1.5 percent, the U.S. bank needs to pay $U.S.100 and the New Zealand bank needs to spend $NZ150.
Calculate the first company's interest obligation. The American company has borrowed New Zealand dollars, so it needs to use the New Zealand interest rate. Assume here that it is five percent. The U.S. company owes $NZ7.50.
Calculate the second company's interest obligation. It has U.S. dollars, so it needs to pay U.S. interest rates. Assume the U.S. interest rates are at three percent. The NZ company owes $US3.
Find the exchange rate for the time of the payment. Assume that it has changed to 2.0. The NZ company still owes the U.S. company $US3. But the U.S. company is able to exchange pay is obligation of $NZ7.50 into $US3.75.
Subtract the smaller value from the smaller value to net the payments. This year, the U.S. company owes more. 3.75-3=0.75. The U.S. company's swap rate for this year is 75 cents, or 0.75 percent, while the NZ company's is 0.
Sam Grover began writing in 2005, also having worked as a behavior therapist and teacher. His work has appeared in New Zealand publications "Critic" and "Logic," where he covered political and educational issues. Grover graduated from the University of Otago with a Bachelor of Arts in history.