SWAPS ARE DERIVATIVE SECURITIES in which two entities (called by convention the "party" and the "counterparty") each take out a loan in a market in which they have preferred access and then swap to the market in which they want to be. The concept is best understood through example, which we undertake here for the two major types of swaps, currency swaps and interest rate swaps. The examples are simplified but capture the essence of the transactions.

Currency swaps

Northern Telecom is a Canadian company, which, we will assume, plans to open a plant in France. Its operating income will be in francs, so the company faces exposure to foreign exchange risk (i.e., the risk that the franc depreciates against the Canadian dollar). It would like to have its expenses denominated in francs so as to reduce this exposure. This is called an "operating hedge." Consequently, Northern Telecom would like to borrow the money for the plant in francs rather than in dollars.

EDF Industrie is a French company, which, we will assume, plans to open a plant in Canada. Its operating income will be in dollars, and it faces currency risk opposite to that of Northern Telecom, i.e., its risk is that the dollar depreciates against the franc. Consequently, EDF would like to borrow the money for its plant in Canadian dollars to hedge its operating income.

Northern Telecom, then, wants to borrow in France, while EDF wants to borrow in Canada. Northern Telecom, however, is better known in Canada than in France, and could borrow more easily and on better terms in Canada than in France. In the same way, EDF has preferred access to the French market.

The solution to this dilemma is as follows. Northern Telecom borrows in Canada and EDF borrows a similar amount in France. The two companies then swap their debt obligations, with Northern Telecom assuming the interest payments denominated in francs and EDF assuming the interest payments denominated in Canadian dollars. Both companies are better off then if they had borrowed directly in the currency of choice.

Interest rate swaps

Northern Telecom also wants to borrow (we will assume) some money in Canada to finance its domestic operations. It wants to borrow at a floating rate, which would cost it seven percent, but it could also borrow at a fixed rate of eight percent. With the floating rate loan, as the name suggests, the interest rate fluctuates over time, but with the fixed rate loan it does not.

Meanwhile, Boondock Mining wants to borrow at a fixed rate, which would cost it 16 percent, but it could also borrow at a floating rate of 11 percent. Notice that the fixed rate market has a risk premium of eight percentage points (16 percent for Boondock versus 8 percent for Northern Telecom) because of Boondock's higher risk, while the floating rate market has a risk premium of only four percentage points (11 percent versus 7 percent). These spreads are common, as the fixed rate market tends to differentiate more on credit risk than does the floating rate market. Northern Telecom in this example has preferred access to the fixed rate market.

To summarize, Northern Telecom wants a floating rate loan, which would cost seven percent, while Boondock Mining wants a fixed rate loan, which would cost it 16 percent. Both companies can do better by arranging a swap, as follows. Northern Telecom borrows in the fixed rate market (at eight percent), while Boondock borrows at the floating rate of 11 percent. They then swap the loans to arrive in their preferred markets.

Boondock is obviously well ahead of the game at this point, nominally paying a fixed rate of eight percent instead of the 16 percent it would pay if it borrowed on its own. Northern Telecom appears to be the loser, paying a nominal rate of 11 percent versus the seven percent it would pay on its own. However, if Boondock pays to Northern Telecom annually the equivalent of six percent of the loan, Boondock's effective cost of the loan becomes 14 percent (eight plus six), while Northern Telecom's effective cost becomes five percent (eleven minus six). Both companies have reduced their effective rates by two percentage points (14 percent versus 16 percent for Boondock and 5 percent versus 7 percent for Northern Telecom).