In the late 1970's, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty.
Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position.
Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement leads to development of more sophisticated swap market of today.
A Swap is a contract between two parties, referred to as counterparties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counterparties.
Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
Facilitators
The problem of locating potential counterparties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counterparty. Dealers work for investment, commercial or merchant banks. "By positioning the swap", dealers earn bid-ask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party.
In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer is a counterparty paying fixed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as futures to cover an exposed position until the book is complete.
Swap brokers, unlike a dealer do not take on a swap position themselves but simply locate counterparties with matching needs. Therefore, brokers are free of any risks involved with the transactions. After the counterparties are located, the brokers negotiate on behalf of the counterparties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counterparties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.
Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position.
Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement leads to development of more sophisticated swap market of today.
A Swap is a contract between two parties, referred to as counterparties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counterparties.
Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
Facilitators
The problem of locating potential counterparties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counterparty. Dealers work for investment, commercial or merchant banks. "By positioning the swap", dealers earn bid-ask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party.
In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer is a counterparty paying fixed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as futures to cover an exposed position until the book is complete.
Swap brokers, unlike a dealer do not take on a swap position themselves but simply locate counterparties with matching needs. Therefore, brokers are free of any risks involved with the transactions. After the counterparties are located, the brokers negotiate on behalf of the counterparties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counterparties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.