Derivative instruments and pricing basics - Swaps: interest ...

Learning Outcomes

This article explains the structure, use, and pricing of swaps in financial management, with a focus on interest rate and currency swaps. You will learn how swaps function to manage risk, reduce borrowing costs, and facilitate international finance. By the end, you will be able to analyse the mechanics of swap transactions, identify where swaps add value, and apply swap logic in ACCA AFM exam scenarios.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand derivative instruments and the mechanics of swaps as a risk management tool. In particular, focus on:

• The role and purpose of swaps in financial risk management
• The structure and application of interest rate swaps
• The design and use of currency swaps in international finance
• How comparative borrowing advantages enable cost savings via swaps
• Methods for calculating net benefits and effective interest rates arising from swaps
• Risks and limitations associated with swap transactions

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes the main use of an interest rate swap?
   1. To exchange principal amounts in different currencies.
   2. To convert fixed rate debt to floating rate debt or vice versa.
   3. To buy or sell shares at a fixed future price.
   4. To speculate on market interest rates.

2. True or false? In a typical fixed-for-fixed currency swap, principal amounts are exchanged at both inception and maturity at a predetermined rate.

3. Company M can borrow at a fixed rate of 5.5% or a floating rate of SONIA + 0.9%; Company N can borrow at a fixed rate of 7.2% or a floating rate of SONIA + 1.8%. Which company holds the comparative advantage in fixed rate borrowing?

4. Briefly explain how both parties can benefit from entering into a currency swap, even when market rates differ.

Introduction

Swaps are a key tool in modern financial management for managing exposure to interest rates and currencies. They allow organisations to exchange streams of cash flows, typically to access better borrowing rates or to hedge against adverse movements. Understanding how swaps are structured and priced is fundamental for the ACCA AFM exam.

Key Term: swap
A contractual agreement between two parties to exchange cash flow streams, typically to manage risk or reduce financing costs.

THE BASIC STRUCTURE OF SWAPS

Swaps come in various forms, but the two main types relevant for ACCA AFM are interest rate swaps and currency swaps.

Interest Rate Swaps

Interest rate swaps involve two parties exchanging interest payments based on the same principal amount but calculated at different rates. The most common version is the fixed-for-floating swap, where one party pays a fixed rate and receives a floating rate, or vice versa.

Key Term: interest rate swap
An agreement to exchange interest payment obligations—one based on a fixed rate and the other on a floating rate—without exchanging the actual principal.

Currency Swaps

Currency swaps involve the exchange of principal and interest payments in different currencies. These contracts typically specify the amounts to be exchanged at the start and the end, fixing the exchange rate for both principal and periodic payments.

Key Term: currency swap
A contract where two counterparties exchange interest and principal payments in different currencies, usually at agreed exchange rates and intervals.

THE ECONOMIC RATIONALE FOR SWAPS

The main purpose of swaps is to allow firms to:

• Benefit from comparative borrowing advantages in different markets.
• Manage interest rate risk or currency exposure.
• Lower overall financing costs compared to direct borrowing.

Key Term: comparative borrowing advantage
The ability of a borrower to access relatively more favorable terms in one financial market (fixed or floating rate, or a particular currency) than another party, enabling both to benefit through a swap.

Key Term: notional principal
The reference amount upon which swap payments are based; no actual exchange of this amount usually occurs in interest rate swaps.

HOW SWAPS CREATE VALUE

A swap generates value for both parties when each has a comparative advantage in a specific borrowing market. By each party borrowing where they have an advantage and then swapping cash flows, both obtain lower effective rates than if they had borrowed directly.

Worked Example 1.1

Company A can borrow at a fixed rate of 4.8% or a floating rate of SOFR + 0.6%. Company B can borrow at a fixed rate of 6.2% or a floating rate of SOFR + 1.4%. Both require $10 million, but A wants floating and B wants fixed. How can a swap benefit both companies?

Answer:

1. Company A has a relative advantage in fixed rate markets (difference: 1.4%), while B is less disadvantaged in floating (difference: 0.8%).
2. Both borrow where they enjoy the greatest advantage (A: fixed at 4.8%; B: floating at SOFR + 1.4%).
3. Enter a swap: A pays B SOFR + x% and receives a fixed rate from B.
4. The terms are structured so both parties end up with better rates than if they borrowed directly in their desired market.
5. The total saving of 0.6% (the difference between relative advantages) can be shared.

Exam Warning

Always calculate the net cost to each party after the swap to determine who benefits and by how much. Be careful to consider intermediary fees if a bank arranges the swap.

HOW INTEREST RATE SWAPS OPERATE

The mechanics are straightforward:

1. Both parties independently obtain loans—one fixed, one floating.
2. They enter into a swap agreement to exchange interest payments.
3. The notional principal is used solely for calculation; it is not exchanged.

Payments are typically netted, so only the difference is paid on each payment date.

Worked Example 1.2

Company C borrows $20 million at 6% fixed. Company D borrows $20 million at LIBOR + 1%. The two companies swap their payment obligations. What payment flows take place if the next LIBOR fixing is 5.5%?

Answer:

• C pays D LIBOR + 1% (in this period: 6.5%) on $20m.
• D pays C 6% fixed on $20m.
• Net settlement: C pays D the difference (6.5% – 6% = 0.5% of $20m over the payment period), since LIBOR + 1% is higher.
• No principal is exchanged.

CURRENCY SWAP STRUCTURE

A currency swap exchanges both principal and interest, in different currencies, at both the beginning and end of the contract. This allows both parties to fix future currency flows, hedge exchange risk, and sometimes access markets with better rates.

1. At inception, principal amounts are exchanged at an agreed rate.
2. Over the life of the swap, each party makes interest payments in the borrowed currency.
3. At maturity, the principal is re-exchanged at the original exchange rate.

Worked Example 1.3

Company E, based in the UK, wants to borrow $15m for US operations and can borrow GBP at 4% or USD at 6%. Company F, a US firm, wants to borrow £10m and can borrow USD at 5% or GBP at 7%. The spot rate is £1 = $1.5. How can a currency swap benefit both?

Answer:

1. E borrows £10m at 4%, F borrows $15m at 5%.
2. Principal amounts (£10m and $15m) are exchanged at the spot rate.
3. E uses $15m for US operations, F uses £10m in the UK.
4. Both pay interest in native currency, but swap interest obligations, so each pays interest at the "cheaper" home rate on the foreign currency borrowed.
5. After maturity, principal is swapped back.
6. Both obtain effective rates below what direct borrowing would allow.

BENEFITS AND RISKS OF SWAPS

Main benefits:

• Access to more favourable borrowing costs
• Hedging against interest rate or currency risk
• Predictable cash flows

Risks to consider:

• Credit risk of default by the counterparty
• Basis risk if floating rates are referenced differently
• Legal and documentation risk

Key Term: basis risk
The risk that the floating rates referenced in a swap do not move in perfect correlation, resulting in unexpected costs or benefits.

Summary

Swaps are strategic instruments that enable companies to exchange interest or currency payment streams to manage risk and reduce costs. By capitalising on comparative advantages and sound structuring, both parties can achieve better borrowing outcomes while managing risk—provided all terms and market conditions are thoroughly assessed.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and explain the structure of interest rate swaps and currency swaps
• Identify and calculate comparative borrowing advantages in swap contexts
• Explain how swaps are used to reduce interest or currency risk
• Understand the mechanics of principal and interest payment exchanges in swaps
• Recognise typical risks associated with swap transactions

Key Terms and Concepts

• swap
• interest rate swap
• currency swap
• comparative borrowing advantage
• notional principal
• basis risk