Swap operations

Introduction

Within our social, cultural, political and economic framework, innovations have been created and developed for the benefit and growth of man. Thanks to them, opportunities have been taken that allow the social and economic evolution of our environment, which is why it is important to embrace technology and new projects, as an alternative for professional growth and expansion.

Within the development of this work, one of the most important operations is disclosed, which companies can develop to grow their capital with greater performance and effectiveness, in such a way that if it does not have immediate liquidity, an exchange or transaction can be made. in order to take advantage of opportunities and grow their economic activity.

This opportunity offered by the market for business development and sustainability are SWAP operations, which generally represent a restructuring of the investment portfolio, through a transaction of securities with certain characteristics and others that may affect the investment portfolios positively.

Historical review

Although this operation came into existence only in very recent years, it can be related to the 1800s and Ricardo's Law of Comparative Advantage. In essence, this law examined two countries both of which produced cloth and wine.

If country A can produce cloth more efficiently than country B, then it has an absolute advantage in cloth over country B. However, according to Ricardo's Law, even if A has an absolute advantage in cloth and wine over B, there is no reason that the two of you cannot negotiate.

Country A should concentrate on producing the product in which it has the greatest comparative advantage, leaving the production of the other product to B. The two can then exchange their excess supplies with each other, allowing both to fulfill their requirements for the product. that they do not produce - with the net result that both would benefit.

SWAP operations correspond to a set of individual transactions through which the exchange of future flows of securities, associated with said individual operations, is made possible by means of such a mechanism, to carry out the restructuring of one of these securities placing it under market conditions.

The purpose of exchanging such future flows is to reduce liquidity, rate, term or issuer risks, and allows the restructuring of portfolios, where it is possible to provide added value for the user who originates the restructuring.

Longer-term securities can be exchanged for several short-term securities; interest rates from a variable to a fixed rate; or exchange of debt for shares. This is done in order to generate liquidity, increase the rate, decrease the term or replace the portfolio's issuers, depending on the risk to be reduced.

Benefits

SWAPs are generally used to reduce financing costs and risks or to overcome barriers in financial markets, that is, a Swap is a financial transaction in which two contractual parties agree to exchange monetary flows over time. Its objective is to mitigate fluctuations in currencies and interest rates.

How do they operate?

A person or company sells to the Central Bank of Chile, through a financial institution, an amount of dollars at the exchange rate set by said Agency for this type of operation. At the same time, it acquires, due to this fact, the right to buy back the same amount of dollars on a fixed date, at a change that is determined taking as a reference the original sale change, plus the variation of the Development Unit that occurred to date of the repurchase, less a percentage equivalent to external inflation determined by the Central Bank. These rights, in turn, generate the seller, normally, an annual interest payable at maturity, as long as the aforementioned repurchase option is exercised.

In this sense, the sale of dollars and their subsequent repurchase are generally not pursued, but the obtaining of financial resources in national current currency, providing foreign currency as collateral. The foregoing protects the entity against eventual devaluations of the local currency, since the fund has not definitively disposed of the foreign currency, but has obtained the necessary financial resources.

In general, the intention of the entities that enter into swap contracts is to exercise the purchase option established in them, unless unusual circumstances make this option inconvenient.

For the entity that signs the swap contract, the following must be recorded individually for each one:

The delivery of its resources in dollars to the Central Bank, charged to a current asset account and credited to the account that recorded the resources delivered, for the amount at which the latter were recorded (at the applicable exchange rate, depending on their origin) Receipt of cash in national currency, charged to the corresponding account and credited to a current liability that represents the obligation derived from the intention to exercise the repurchase option The asset and liability accounts used to record the contract swap mentioned above, must be adjusted to the closing date of each financial statement, as follows:

The current asset account mentioned in the preceding paragraph must be adjusted to the applicable exchange rate, depending on its origin, in force on the closing date of the financial statement. The abovementioned liability account must be adjusted to the exchange rate agreed for its current repurchase. as of the closing date of the EEFF.

Types of swap operations

Interest Rate Swap

This type of Swap is the most common and seeks to generate greater liquidity, especially to one of the parties involved in the operation, and to the other gains on acquisitions, although for a longer term, in this it is played with the interests but the parties have in It also takes into account the values and the terms, in general, interest is exchanged from a fixed to a variable rate or vice versa, thus involving a risk as any financial operation has.

Ex.

Currency swap

It is a financial contract between two parties who want to exchange their main currency in different currencies, for an agreed period of time. During the time period of the agreement, the parties pay their mutual interest.

The above:

It breaks the entry barriers in international markets. The cost of the service is lower than without the Swap operation. It has a contractual form, which requires the payment of reciprocal interest. It is usually done through intermediaries

Swap on raw materials:

Through this type of Swap, many companies, especially in the manufacturing sector, have been able to generate greater liquidity for their organizations.In this type of transaction, the first counterpart makes a payment at a fixed unit price, for a certain amount of some raw material, then the second. The counterpart pays the first a variable price for a certain amount of raw material, the raw materials involved in the operation may be the same or different.

For companies, it is much more favorable to carry out these transactions because in this way they avoid credit risk, assuming only market risks, especially from the party that makes variable payments, the advantage is that the latter can enter to negotiate prices, quality, etc., of raw materials, taking into account that it is the part that assumes the greatest risks.

Example: a three-year swap on oil; This transaction is an exchange of money based on the price of oil (A does not deliver oil to B at any time), therefore the Swap is responsible for compensating any difference between the variable market price and the fixed price established through the Swap. That is, if the price of oil falls below the established price, B pays A the difference, and if it rises, A pays B the difference.

Stock indices swap:

The Swaps market on stock indices allows to exchange the performance of the money market for the performance of a stock market, this performance refers to the sum of dividends received, capital gains and / or losses.

Currency swap

These types of operations allow the principal of the parties to be exchanged in different currencies at the exchange rate set in the market, which allows breaking down the entry barriers in international markets and negotiating in them without much difficulty without having to go directly to these capital markets.

Eg: a company wants to acquire machinery and raw materials in a certain country but to carry out the operation it is necessary to do so in local currency, a similar case occurs with a company from that country that wants to carry out operations in the country of origin of the first; When performing a Swap operation, both companies have the possibility of exchanging their principal for the currency of the opposite country to finance their operations, this operation allows them to reduce costs and the time that each of them would have to invest if they carried out the currency exchange operation in the traditional way, and as already mentioned without having to go directly to these capital markets.

characteristics

The SWAP was created to carry out structured financial operations in such a way that it satisfies the needs of a particular client, who wishes to substitute securities of one portfolio for another, in order to modify their profitability, liquidity, duration or solvency, however this has some features that are worth highlighting:

Type of Risk Participants

Risk types

Since SWAP is a hedging mechanism that allows covering market, solvency and liquidity risks, when carrying out any SWAP operation, the type of risk that the originator of the SWAP is covering must be indicated, taking into account the following:

Market Risk: Market risk is understood as the contingency of loss or gain due to the variation in the market value, compared to that registered in the valuation of the investor's portfolio, as a result of changes in market conditions, including variations in interest rates. interest or exchange rates.

Solvency Risk: Solvency risk is understood as the contingency of loss due to the deterioration of the financial structure of the issuer or guarantor of a security, which may generate a decrease in the value of the investment or in the capacity to pay, in whole or in part., of the returns or of the capital of the investment.

Liquidity Risk: This risk considers the need of the security holder to make a long-term security liquid, causing a possible loss or gain.

Paragraph: The type of risk must be reported to the Stock Exchange at the time the securities are entered into the trading system, and in any case in the daily information report that may arise.

Participants

At least three types of agents must participate in any SWAP.

Originator: He is the one who needs to cover a specific risk and uses the figure of substitution of securities -SWAP-. It must take a position of initial seller of a first security originating the risk and final buyer of a second security that meets the characteristics to cover the portfolio risk that gave rise to the operation. These sections of SWAP operations will not be subject to market prices, however, it is necessary for the brokerage firms to obtain written communication from this client in which they clearly and expressly state that they are aware of current market conditions and are willing to carry out such operations. Turning Agent: It is in charge of turning over the originator's securities, acting as an intermediary. Its position must be neutral and its utility will be basically determined by the difference in prices, and this cannot be negative in any case nor can it be corrected with profits from other operations independent of the SWAP in question. The turner may only buy the securities in final position when previously authorized by the originator through written authorization. Third: It can be one or more third parties that intervene in this category. He is the one who sells the title (s) that will replace the original title of the SWAP and who buys the title that gave rise to the SWAP operation. When two independent third parties present themselves, these operations will be carried out with the turning agent and will be governed by real market prices.

People or institutions in charge of issuing it

Foreign exchange market intermediaries Brokers that are members of the clearing houses of foreign futures and options exchanges, classified as first category according to general regulations adopted by the Banco de la República Foreign financial entities classified as first category according to general regulations adopted by the Banco de la República.

How are they issued?

SWAPS transactions are typically conducted over the phone or internet and the deal is closed when an agreement is reached on the coupon rate, the basis for the floating rate, the day basis, start date, expiration date, due dates. rotation, applicable law and documentation.

The transaction is confirmed immediately by telex or fax followed by a written confirmation. The documentation used in the main currency centers is generally in one of two standard forms, that offered by the British Bankers Association (BBAIRS) or the International Association of Swap Agents.

Type of risk

Differential risk: This occurs when a Swap is covered with a bond, and there is a change in the Swap differential with respect to the bond, which causes a loss or a profit in the Swap's profitability. Base risk: This type of risk and it is very common because many of the companies that carry out these operations do not correctly foresee the difference that can occur between the reference rates and the rates implicit in the future contract, which in the end causes a loss for one of the companies. Credit risk: It is a type of risk, as already mentioned, refers to the fact that the counterpart does not comply with its obligations. This risk always tends to increase when the interest obligations are exchanged in different currencies.Risk of reinvestment: It is derived from credit risk,when there are changes in the payment dates, it is necessary to reinvest on each rotation date. Exchange rate or exchange rate risk: This type of risk occurs frequently, especially in currency swaps, when having to pay more than one's own currency or any other to acquire the same amount of currency that was agreed in the contract, which ultimately affects the cost of the transaction.

Job analysis

Financial swaps or Swaps have become in recent years one of the most used tools to break the trade barriers imposed by many countries as well as instruments to generate greater liquidity for companies around the world in the shortest time and with the least amount of costs.

These types of operations allow many organizations to access certain currencies or obtain interest rates under more advantageous conditions.

Swaps also allow reducing market, solvency and liquidity risks, among others.

In almost all Swap operations and to ensure their success, it is important that three agents participate in this one, an originator who is the one who needs to cover a risk and the initial seller of the title that originates it, a turning agent who acts as an intermediary who knows the legal conditions in which the operation must be carried out and who guides the other two parties so that it reaches a successful conclusion; and a third party who is the one who sells the title that will replace the original Swap title and who buys the title that gave rise to the operation.

The efficiency of the global capital market and truly knowing its behavior allows a correct use and performance of the Swap operation.

The Swap can become a contingency instrument in the company's plans in the face of unexpected events, especially illiquidity.

There are different types of Swap such as interest rates, raw materials, currencies, stock indices; For this, it is necessary to analyze which of them covers correctly and fits the transaction that you want to carry out and the interests that are involved.

As in any transaction, there are risks that can be avoided if the contract is signed correctly.

SWAP operations are a set of contractual transactions that must be carried out with a solid intermediary and that complies with the characteristics mentioned in this work, since due to ignorance, an entrepreneur can be affected by not knowing the rules involved for such operation.

Likewise, care must be taken when securities are exchanged in such a way that a short-term profit is always obtained, which is the purpose of the operation.

Although every operation carries a risk, it is essential to know how to face it with the greatest insight because if the appropriate exchange rates and interests are managed, the original creditor company of the transaction may be the most benefited.

Conclusions and recommendations

In recent years, the swap market has grown considerably, mainly due to the growing globalization of markets, in which the diversity in structures and institutions made it necessary to use an instrument that would unify their advantages and disadvantages. Furthermore, the promotion and use given by central banks, mainly the World Bank, helped to implement it relatively quickly among the different figures participating in financial markets.

Thanks to the contribution of the market, in allowing these operations to be carried out, many companies have achieved a competitive advantage that allows an effective restructuring of their portfolios and to improve their economic capacity in an exponential and lasting way.

For this reason, swaps are a financial instrument used in order to reduce financing costs, as well as their risks, which generates greater liquidity and solidity in their assets.

Thanks to these operations, the changes in currencies or interest rates to which they are exposed are reduced, since a transaction of this magnitude manages to set a rate for the currency in such a way that it does not suffer from bad market transformations and its constant deterioration.

The operations not only allow two or more parties to exchange the advantages they can obtain in their respective markets. But they are also intended to directly or indirectly restructure your debts, and also reduce the financial cost of all parties.

Currently there are two types of swap operations that represent more than 90% of the operations carried out in the world: interest rates and currencies, which are the most used due to their level of profit and profit.

As well as operations offer great opportunities for entrepreneurs, great complications can also be generated if the rules of these are not clearly known, since under this modality they can only be issued by authorized entities, as in the case of our country the Bank of the Republic, who is the one who gives the power for certain banking entities to carry out this type of transaction.

With the foregoing, it is recommended that companies that are empowered to be this type of operations, know the weaknesses and benefits of the operations, since in many cases, due to ignorance, opportunities that can affect the portfolio of services may arise.