International Financial Management - Essay Example

Interest rate swaps are especially useful where on one hand, a firm wants to receive/make payment in the form of a variable interest rate and on the other hand another firm which prefers instead to receive/make payment in the form of fixed interest rate so as to limit its future risk. The first swap was executed over thirty years ago (Corb, 2012). The rationale behind such a derivative instrument is that, both parties to the financial arrangement have their own distinct priorities and requirements such that in swapping, there is a mutual benefit to be derived.

This benefit arises from three major elements of the capital market: The comparative advantage, information asymmetries and fixed rate debt vis-a-vis the embedded options (Flavell, 2010). In essence, the monetary gain one party makes through the swap contract is equal to the monetary loss of the counterparty to the contract. This is to say that although there is the overall benefit of a minimized risk arising from uncertainties within the financial market, one party to the contract will incur some monetary loss. . The most common forms of interest rate swaps include: Fixed for floating interest rate swap Floating for fixed interest swaps Same currency swaps Different currency swaps Discussion For firms such as ABC limited, a variable for fixed interest rate swap is very desirable.

Firstly, with regard to synthetic fixed rate financing (also referred to as signaling). The asymmetric nature of the information environment means that firms themselves possess a better view of their levels of credit risks. As such, they require a credible way(s) of transmitting such information to the investors within the market. The firm’s borrowing of a short term debt instrument and swapping it for a fixed debt instrument signals good levels of credit of the firm to the market (Flavell, 2010).

A firm is only able to do this in light of its improving future prospects. Any subsequent floating/variable debt instruments sought after will be at better and better rates (since the market can in itself recognize this) provided that the market is sure that the firm’s projected level of credit is sound. Ordinarily, the market reacts harshly to any false signaling by firms about their credit levels. The market conducts a comparison of the firm’s signal now and its performance in the subsequent period; where the firm’s credit has not risen, the market assumes that the signaling was false and retrospectively the market may downgrade the firm’s credit rating by more than usual.

Secondly, the underlying principal is not exchanged or swapped. This means that the maximum loss is substantially minimized to the net payments to the counterparties of the swap contract. Additionally, where the interest rate on floating debt