Swaps

Swaps literally means exchange.

An agreement between the two parties to exchange a series of payments the terms of which are predetermined can be considered as financial swap.

Financial swap are broadly classified into

Interest Rate Swaps
Currency rate Swaps

Interest Rate Swaps

In the interest rate swaps or the plain vanilla swap the fixed rate obligations are exchanged for floating rate obligations over a specified period of time for a notional principal.

Let us assume that X & Y enter the interest rate swap agreement wherein X lends to Y at LIBOR and Y lends to X at fixed rate 10% .

The net cost of funds to X and Y using the swap agreement can be seen by examining their cash flows.

Currency Swaps

Currency swaps involve three steps, although the first step may be notional.
Initial exchange of principal
Exchange of interest rates
Re-exchange of principal at the end of the contract.

Generally this are known as cross- currency swaps

A cross-currency swap is an interest rate swap in which the cash flows are in different currencies. Upon initiation of cross currency swap, the counterparties make the initial exchange of the notional principals in the two currencies. During the life of the swap, each party pays interest( in the currency of the principal received) to the other. And at the maturity of the swap, the parties make a final exchange of the initial principal amounts, reversing the initial exchange at the same spot rate.

Generic cross currency swap: A 5 year EUR/USD example (Spot =1.30)

The figure above illustrates a structure in which the company receives USD interest and pays EUR interest. The front and back exchanges of principal amounts are based on the current spot rate. The grey Euro cash flows are economically equivalent to issuing a Euro bond; the USD cashflows are equivalent to investing in a USD bond. If paired with a USD borrowing, the CCS converts the USD borrowings into a synthetic EUR one; if paired with a EUR investment, the CCS converts the EUR asset into a synthetic USD one.