Interest Rate Swaps Research Paper

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Interest Rate Swaps - International Financial Management
Introduction
Interest rate swaps are a financial instrument that firms use to hedge themselves against interest rate exposures by exchanging interest rate obligations with each other (Smith, 2011). Interest rate exposure is the risk that a firm can make financial losses when the interest rates on the firm’s liabilities/assets move unfavorably (upwards and downwards respectively) against it within the financial market. It also refers to the opportunity for gain when interest rates in the financial market drop on these very same liabilities.
The rationale behind such a derivative instrument is that, both parties to the financial arrangement have their own distinct priorities and requirements …show more content…

Firstly, with regard to synthetic fixed rate financing (also referred to as signaling). The asymmetric nature of the information environment means that firms themselves possess a better view of their levels of credit risks. As such, they require a credible way(s) of transmitting such information to the investors within the market. The firm’s borrowing of a short term debt instrument and swapping it for a fixed debt instrument signals good levels of credit of the firm to the market (Flavell, 2010). A firm is only able to do this in light of its improving future prospects.
Any subsequent floating/variable debt instruments sought after will be at better and better rates (since the market can in itself recognize this) provided that the market is sure that the firm’s projected level of credit is sound. Ordinarily, the market reacts harshly to any false signaling by firms about their credit levels. The market conducts a comparison of the firm’s signal now and its performance in the subsequent period; where the firm’s credit has not risen, the market assumes that the signaling was false and retrospectively the market may downgrade the firm’s credit rating by more than …show more content…

Forward contracts
Under a forward contract, ABC limited would enter into a contract with the bank on a particular currency for the amount payable, the exchange rate on that currency versus another (which is set independent of the current exchange rate or spot rate) and on the date for which such an exchange rate matures. Upon the contract’s maturity, the firm would exchange some amount of foreign currency for that which it owes to the bank in the full settlement of the principal amount borrowed plus interest accumulated whether or not the exchange rate has changed.
Key to note is that the firm has the right to exercise the forward exchange rate or not depending on whether the exchange rate has caused a depreciation or appreciation of the debt currency. If the exchange rate moves unfavorably, the firm can exercise the forward contract; if it moves favorably; the firm lets the option expire and makes the repayments at the prevailing exchange rate.
2. Money market

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