Friday, September 4, 2009

Swap - A concept to remember

Couple of weeks back we went to ‘Kaminey’...Not a very exciting movie, I would say, except for couple of facts..One – Priyanka Chopra, who is becoming more beautiful with every passing day …Second – I got an example to explain the concept of ‘Swap’ in financial market...

Two parties in the financial market enter into a swap agreement when they feel the agreement can bring in mutual benefit to each other (which would not have existed individually)…

Example: Shahid Kapoor vs Shahid Kapoor..

Group of Mafias would be searching for Shahid Kapoor 1 in the movie (elder of the twins) and the police would be searching for Shahid Kapoor 2..Now each of the Shahid kapoor will get caught in the hands of the wrong party (ie SK1 in the hands of police and SK2 in the hands of mafia)…Now assume if both the parties (police and mafia) had to take the trouble of getting the other person, it’s going to cost them huge resources , time , money….

But once they get to know the whereabouts of the Shahid Kapoors they enter into a private agreement (Rule no 1: Swap is a private agreement as opposed to futures or options) , to exchange the Shahid Kapoors..

Very easy right…This is all what Swap is about…

Example 1 in financial market: ICICI wants to raise Euros to serve its High net worth client(say maruthi …because maruthi has some parts manufactured from Britan and hence has a liability in Euros)..And a bank in Europe say Bank of England wants Indian currency to serve its client (say an FDI who wants to invest in India and hence needs rupees)..

If ICICI wants to borrow Euro the cost would be somewhere around 5% and if BOE wants to borrow Indian Rupee it would cost them around 10-11 %(approximate figures)..But if ICICI wants to raise money in India it is just the cost of deposit for them which would be like 7-8%(or even in debt markets around 9%) and for BOE it would be around 3% in their own backyard for raising Euros..

So both of them enter into a private deal..You raise money in your country and I’ll do it in my country and we’ll swap it amongst ourselves..ICICI will be able to get euros from BOE at say 4%(a net saving of 1%) and BOE will be able to get it at 9% from ICICI(around a percent of savings)..Both of them will mostly enter into a deal such that the mutual gain for each of them are equal(but not a necessary condition..depends upon the bargaining power)…

Example 2:Another case could be when one bank within the same country is trying to raise fixed rate loans because of its balance sheet structure(I don’t want to confuse you by introducing the technical terminologies) and another bank wants to raise floating rate loans . But they are able to give loans in the other way(floating and fixed respectively) ..Now they enter into a swap deal so that it benefits both of them…First bank gets the fixed loans and second bank gets the floating loans

So simple right….All finance concepts are very simple…It would be denefitly a concept which we would have unconsciously used in some time in our life..Just that they are embedded into complex names: P

PS:If you are further interested abt swaps just go through existing literature on ‘valuing swaps’…I promise you that it’ll not take more than fifteen minutes to understand how is a swap valued..It is interesting as well!!

1 comment:

  1. as you said all finance concept are simple, they are just embedded into complex, what comes to my mind is...if we could relate ex:1 with age old hawala system which is illegal but process resemble swap...??