Swaps permits institutions to exchange one flow of payments with another, in addition to hedging income gaps existing in the organizations. Swaps are contractual agreements between two parties who agree to exchange a stream of cash flows for a specified period, known as the “tenor.” These cash flows depend on agreed-upon parameters and the price fluctuations in a specified underlying asset, commodity, or market index. Swap markets emerged to address the increased currency and interest-rate volatility after the collapse of the Bretton Woods fixed exchange rate system. They are known to lessen risk; reduce borrowing costs; and assist in avoiding unnecessary costs arising from changes in the balance sheet.
The following advantages can be derived by a systematic use of swap:
1. Borrowing at Lower Cost:
Swap facilitates borrowings at lower cost. It works on the principle of the theory of comparative cost as propounded by Ricardo. One borrower exchanges the comparative advantage possessed by him with the comparative advantage possessed by the other borrower. The net result is that both the parties are able to get funds at cheaper rates.
2. Access to New Financial Markets:
Swap is used to have access to new financial markets for funds by exploring the comparative advantage possessed by the other party in that market. Thus, the comparative advantage possessed by parties is fully exploited through swap. Hence, funds can be obtained from the best possible source at cheaper rates.
3. Hedging of Risk:
Swap can also be used to hedge risk. For instance, a company has issued fixed rate bonds. It strongly feels that the interest rate will decline in future due to some changes in the economic scene. So, to get the benefit in future from the fall in interest rate, it has to exchange the fixed rate obligation with floating rate obligation. That is to say, the company has to enter into swap agreement with a counterparty, whereby, it has to receive fixed rate interest and pay floating rate interest. The net result is that the company will have to pay only floating rate of interest. The fixed rate it has to pay is compensated by the fixed rate it receives from the counterparty. Thus, risks due to fluctuations in interest rate can be overcome through swap agreements. Similar, agreements can be entered into for currencies also.
4. Tool to correct Asset-Liability Mismatch:
Swap can be profitably used to manage asset-liability mismatch. For example, a bank has acquired a fixed rate bearing asset on the one hand and a floating rate of interest bearing liability on the other hand. In case the interest rate goes up, the bank would be much affected because with the increase in interest rate, the bank has to pay more interest. This is so because, the interest payment is based on the floating rate. But, the interest receipt will not go up, since, the receipt is based on the fixed rate. Now, the asset- liability mismatch emerges. This can be conveniently managed by swap. If the bank feels that the interest rate would go up, it has to simply swap the fixed rate with the floating rate of interest. It means that the bank should find a counterparty who is willing to receive a fixed rate interest in exchange for a floating rate. Now, the receipt of fixed rate of interest by the bank is exactly matched with the payment of fixed rate interest to swap counterparty. Similarly, the receipt of floating rate of interest from the swap counterparty is exactly matched with the payment of floating interest rate on liabilities. Thus, swap is used as a tool to correct any asset- liability mismatch in interest rates in future.
5. Additional Income:
By arranging swaps, financial intermediaries can earn additional income in the form of brokerage.