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The necessary conditions for a fixed-for-floating interest rate

swap to be possible are:

i. Agreement between the two counterparties for such

swap,
ii. Notionally availability of the principal amount i.e. no
actual exchange of principal amount,
iii. Single currency transaction,
iv. A series of payments calculated by applying a fixed
rate of interest to a notional principal amount in
exchange for a stream of payments similarly calculated
but using a floating rate of interest.
v. Presence of swap dealers and brokers,
vi. quality spread differential,
vii. The default-risk premium of the fixed-rate debt should
be larger than the default-risk premium of the floating-
rate debt. etc.

An example of fixed-for-floating interest rate swap is given

below -

p
A is currently paying floating, but wants to pay fixed. B
is currently paying fixed but wants to pay floating. By entering
into an interest rate swap, the net result is that each party
can 'swap' their existing obligation for their desired obligation.
Normally the parties do not swap payments directly, but
rather, each sets up a separate swap with a financial
intermediary such as a bank. In return for matching the two
 parties together, the bank takes a spread from the swap
payments.

` 
 


 
       
     

Basic motivations for counterparty to enter into a currency swap

are:
i. currency risk management,
ii. commercial needs, and
iii. comparative advantage.
The normal business operations of some firms lead to certain
types of interest rate or currency exposures that swaps can
alleviate. For example, a bank which pays a floating rate of interest
on deposits (i.e., liabilities) and earns a fixed rate of interest on
loans (i.e., assets). This mismatch between assets and liabilities
can cause tremendous difficulties. The bank could use a fixed-pay
swap (pay a fixed rate and receive a floating rate) to convert its
fixed-rate assets into floating-rate assets, which would match up
well with its floating-rate liabilities.
Some companies have a comparative advantage in acquiring
certain types of financing. However, this comparative advantage
may not be for the type of financing desired. In this case, the
company may acquire the financing for which it has a comparative
advantage, then use a swap to convert it to the desired type of
financing.
For example, a U.S. firm that wants to expand its operations into
Europe, where it is less well known. It will likely receive more
favorable financing terms in the US. By then using a currency
swap, the firm ends with the euros it needs to fund its expansion.

3. 
 

    
      
 
 


The forward market is an OTC market where the forward

contract for purchase or sale of foreign currency is tailor -made
between the client and its international bank. No money changes
hands until the maturity date of the contract when delivery and
receipt are typically made. A futures contract is an exchange -
traded instrument with standardized features specifying contract
size and delivery date. Futures contracts are marked -to-market
daily to reflect changes in the settlement price. Delivery is seldom
made in a futures market. Rather a reversing trade is made to
close out a long or short position.

4. !     
 

 
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 Two types of market participants are necessary for the
operation of a derivatives market: speculators and hedgers. A
speculator attempts to profit from a change in the futures price. To
do this, the speculator will take a long or short position in a futures
contract depending upon his expectations of future price
movement. A hedger, on-the-other-hand, desires to avoid price
variation by locking in a purchase price of the underlying asset
through a long position in a futures contract or a sales price
through a short position. In effect, the hedger passes off the risk of
price variation to the speculator who is better able, or at least more
willing, to bear this risk.

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A call/ put option with St > E/ E > St is referred to as trading in-the-
money. If St º E the option is trading at-the-money. If St < E/ E <
St the call/ put option is trading out-of-the-money. µSt¶ is the spot
price and µE¶ is the exercise price.

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