Interest Rates Swa[s Require Markets to be Inefficient - Essay Example

Currency exchange tailors international exchange transactions. Interest rates are characteristic of risks that result from the various key constituents of the foreign exchange market. One of these constituents is the interest rate swaps. Foreign exchange and interest rate operations provide opportunities for hedging in the foreign exchange market. Interest rate swaps in this context can be considered to be unique financing arrangements that allow corporations to significantly cut on their credit costs while improving their control on risks that accrue from interest rates and exposure to foreign exchange transactions.

Market for currencies has considerably grown across the entire globe, and so has the interest rate swaps total outstanding amounts in the world (Lowenstein, 2000, pg. 148). The contributing currencies to this fast growth include but not limited to the US dollar, Euro, Japanese Yen and British Pound. Cash flow exchanges in an interest rate swap are undertaken by two parties, who are bound to the interest rate swap agreement. Both parties have high expectations of benefiting from the interest rate swap.

Where only one currency is involved, the resultant swap is called an interest rate swap. On the other hand, where multiple currencies are involved, a currency swap prevails. Corporations engage interest rate swaps in their operations for the purpose of achieving well defined goals. Interest rate swaps are said to be fully operational and beneficial in inefficient markets. There are certain components of the markets without which realization of swaps is rendered void. First, there must be two parties bound to the interest rate swap agreement.

Second, the transactions are undertaken in the context of foreign exchange, where interest rates play a fundamental role in unifying the various currencies. Argument of whether or not interest rate swaps require markets to be inefficient can be evaluated based on the aiding tools of this foreign market constituent. Credit and debt evaluations in the interest rate swaps market can be used to define effectiveness of markets based on interest rate swaps. Quality Spread Differential is an integral component of foreign exchange markets, which is specifically designed for interest rate swaps.

Efficient markets consider that debt instruments carry default risk premiums (De Jong, 2008, pg. 168). In these markets, risk premiums associated with interest rate swaps are mispriced, which is an implication of Quality Spread Differential. In an efficient market, it is expected that swap markets would be alleviated in the long run. However, this is not the case observed around the world. Now and then explosions have characterized the interest rate swap markets. Over time, instead of the markets disappearing, they have increased their operations and the effect there in have taken a maximum notion.

In this regard, the entire market cannot be considered to be efficient. Inefficiency in these markets has increasing interest rate swaps more and more. An efficient market considers facing out swap markets through arbitraging activities. This has not been realized, and it is still far from it because arbitraging has taken centre stage in the foreign market. Interest rates are not stable over time due to the disturbances caused by cyclic business movements to the economy. As a result, arbitrage opportunities emerge from interest rate discrepancies, and all economic components seek to exploit these