Swap options hold particular importance for companies that intend to extend their business internationally. One of the risks related to international business expansion is the fluctuation of interest rates. Changes in interest rates influence the financial performance of an organization in a major way because the extent of the borrowing cost to be paid or received by an organization depends upon the prevailing interest rates. If an unanticipated rise or fall occurs in the interest rates, this may have a significant impact on the cash flow of the organization.
An organization projects its future cash flows in order to evaluate its performance. However, if the interest rates change frequently, the projected cash flows of the organization may not be valid therefore the comparison of the actual performance of the organization with the projected performance may not provide valid results. If an organization holds a loan which is subject to the floating interest prevailing in the market, the finance cost to be paid by the organization will depend upon that prevailing interest rate. The organization will have to bear a lower finance cost if the interest rate falls, however on the other hand, the organization will have to pay a higher amount if the interest rate rises.
Following are some of the swap options that can be utilized by a company to mitigate the risk related to fluctuating interest rates.
Fixed for Floating
In this swap option one of the parties agrees to pay fixed interest rate while the other agrees to pay floating interest rate. The fixed rate is an agreed interest rate which remains constant throughout the term of the loan, while the floating interest rate is referenced to a benchmark such as; LIBOR. This swap option is feasible for long term loans and where there is high level of uncertainty with regard to the interest rates.
For example; interest rate in India was 6% at the start of the year 2011 and it rose to 8% in September and to 8.5% in October 2011. This trend shows that there is high level of uncertainty in the interest rates in this country therefore it will be feasible to use fixed to floating swap option. Similarly, in Brazil the year 2011 started with the interest rate set at 10.25% which reached its highest point at 12.5% in July and fell back to 11% at the end of the year. Within the span of one year, the interest rate in the country rose significantly and fell again. It can be said that the interest rate does not follow a predictable pattern. Thus, there is also uncertainty regarding the interest rates.
In this option, a company can swap interest rates with a local financial institution and agree to pay the finance cost at a fixed interest rate. The other party will charge a fee in exchange for the swap and the extent of the fee depends upon the extent of uncertainty associated with the interest rates. If there is high level of uncertainty regarding interest rates, the counter party will charge a higher fee in order to cover the risk associated with the fluctuating interest rates.
Floating for Floating
In this swap option, both the parties agree to exchange their finance cost obligations by an agreement to pay a floating interest rate in exchange for another floating interest rate. In this option, both the floating interest rates belong to different reference points. For example; one of the floating interest rates may be benchmarked to LIBOR while the other may be benchmarked to TIBOR (Tokyo Interbank Offered Rate).
Fixed for Fixed
In this type of swap option, both the parties agree to pay a fixed interest. The essence of this type of swap option is the exchange of the principal amount which is normally in different currencies. This type of swap option is the most feasible for companies that intend to invest in another country. This swap option provides a company with an option to hold another currency without worrying about the fluctuations of the interest rates.
In this transaction, both the parties exchange their principal amounts which are in different currencies and agree to pay a fixed interest. The effect of exchange rate is also taken into account. Thus, the company holds a significant amount of foreign currency at a relatively fixed exchange rate and at a fixed interest rate. The company can enter into this swap option for a long term as well. In this way, the company can have a well defined and predictable cash flow with regard to its foreign operations. This will also help the company in the consolidation of the financial statements of the company.
Therefore, it can be concluded that swap options are highly important for a company that intends to expand its business internationally as they help in mitigating the interest rate risk.