Use of Swap

The following gains can be derived by the systematic use of swap:

Borrowing at Lower Cost

Swap facilitates borrowings at a 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 parties are able to get funds at cheaper rates.

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 the swap. Hence, funds can be obtained from the best possible source at cheaper rates.

Hedging of Risk

Swaps 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 the future due to some changes in the economic scene.

So, to get the benefit in the future from the fall in interest rate, it has to exchange the fixed-rate obligation with a floating rate obligation.

That is to say; the company has to enter into a 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 a 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 rates can be overcome through swap agreements. Similarly, agreements can be entered into for currencies also.

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 of interest in exchange for a floating rate.

Now, the receipt of a fixed rate of interest by the bank is exactly matched with the payment of fixed-rate interest to the swap counterparty.

Similarly, the receipt of the floating rate of interest from the swap counterparty is exactly matched with the payment of the floating interest rate on liabilities.

Thus, swap is used as a tool to correct any asset-liability mismatch in interest rates in the future.

Additional Income

By arranging swaps, financial intermediaries can earn additional income in the form of brokerage.

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