Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^820) © The McGraw−Hill
Companies, 2002
At the same time, a German firm would like to obtain U.S. dollar financing. It can
borrow cheaply in euros, but not in dollars. Both firms face a similar problem. They can
borrow at favorable rates, but not in the desired currency. A currency swap is a solution.
These two firms simply agree to exchange dollars for euros at a fixed rate at specific fu-
ture dates (the payment dates on the loans). Each firm thus obtains the best possible rate
and then arranges to eliminate exposure to exchange rate changes by agreeing to ex-
change currencies, a neat solution.
Interest Rate Swaps
Imagine a firm that wishes to obtain a fixed-rate loan, but can only get a good deal on a
floating-rate loan, that is, a loan for which the payments are adjusted periodically to re-
flect changes in interest rates. Another firm can obtain a fixed-rate loan, but wishes to
obtain the lowest possible interest rate and is therefore willing to take a floating-rate
loan. (Rates on floating-rate loans are generally lower than rates on fixed-rate loans;
why?) Both firms could accomplish their objectives by agreeing to exchange loan pay-
ments; in other words, the two firms would make each other’s loan payments. This is an
example of an interest rate swap;what is really being exchanged is a floating interest
rate for a fixed one.
Interest rate swaps and currency swaps are often combined. One firm obtains float-
ing-rate financing in a particular currency and swaps it for fixed-rate financing in an-
other currency. Also, note that payments on floating-rate loans are always based on
some index, such as the one-year Treasury rate. An interest rate swap might involve ex-
changing one floating-rate loan for another as a way of changing the underlying index.
Commodity Swaps
As the name suggests, a commodity swapis an agreement to exchange a fixed quantity
of a commodity at fixed times in the future. Commodity swaps are the newest type of
swap, and the market for them is small relative to that for other types. The potential for
growth is enormous, however.
Swap contracts for oil have been engineered. For example, say that an oil user has a
need for 20,000 barrels every quarter. The oil user could enter into a swap contract with an
oil producer to supply the needed oil. What price would they agree on? As we mentioned
previously, they can’t fix a price forever. Instead, they could agree that the price would be
equal to the averagedaily oil price from the previous 90 days. As a result of their using an
average price, the impact of the relatively large daily price fluctuations in the oil market
would be reduced, and both firms would benefit from a reduction in transactions exposure.
The Swap Dealer
Unlike futures contracts, swap contracts are not traded on organized exchanges. The
main reason is that they are not sufficiently standardized. Instead, the swap dealerplays
a key role in the swaps market. In the absence of a swap dealer, a firm that wished to en-
ter into a swap would have to track down another firm that wanted the opposite end of
the deal. This search would probably be expensive and time-consuming.
Instead, a firm wishing to enter into a swap agreement contacts a swap dealer, and the
swap dealer takes the other side of the agreement. The swap dealer will then try to find
an offsetting transaction with some other party or parties (perhaps another firm or an-
other dealer). Failing this, a swap dealer will hedge its exposure using futures contracts.
794 PART EIGHT Topics in Corporate Finance