Free «Swap Options» Essay Sample

Swap Options

Interest Rate Swaps

This is an arrangement between two counterparties to exchange a fixed interest payments on a specific  principal amount over set period of time ,and this normally done over the counter. The arrangement of the swap exchange should be standardized to the requirements of the parties involved. This is because these derivative contracts are usually exchanged by the fixed-interest payment with floating rate payment this becomes an important tool to the investors as they use them to manage the risk.

The most commonly used swap that is being traded is the plain vanilla swap, this is because they are the most liquid interest swaps used in short-term financing. This type of swap involves the exchange of a fixed interest payment for floating rate payment which is normally based on the London Inter-bank Offered Rate (LIBOR) which is the benchmark for short-term rates that are set on daily basis, (Brown, 2009).

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In the vanilla swap there are two parties that are involved and they are defined by the role they play in the swap agreement .That is the swap Receiver and the swap payer. The Receiver chooses to receive the fixed rate and also to pay the floating rate; on the hand the swap payer will receive the floating rate in exchange for fixed interest payment.

The most appropriate swap option that I can advise Dorchester, Inc. management to use is the vanilla swap option; this option is more suitable in the acquisition process of the company. The vanilla swap option is an essential tool because the Dorchester Inc. management will be able to analyze the following before entering into acquisition process: Their portfolio management, speculation, corporate finance, risk management and rate-locks on bonds issuance, (Zeng, 2009).

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1.Portfolio management

The Dorchester Inc. portfolio managers will use Interest rate swaps to adjust the duration, to regulate and offset the interest rate and the risk volatility that the interest payment carries. By raising or lowering the interest rate exposure over the swaps yields will make the managers to decide either to neutralize or substitute the exposure with a less liquid fixed income instrument. On the other hand the managers can decide to prolong the payment of the interest rate so that to increase the duration of the of the portfolio investment, this makes swap option to be an effective technique in a liability driven investment, because the managers will try to match the duration of the available assets with that of the long-term liabilities.

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2. Speculations

Swaps require both capitals up front to both fixed –income trader and large investment. Through this the managers will be able to speculate the movement  or shift of the interest rates this will help them to make a decision on whether to take a long-term or short-term treasury such that  to avoid unnecessary cost involved. For example if managers speculate that in the next six years the interest rate will fall then they should advice the company to take appropriate action by receiving a six years fixed rate swap transaction that can offer the same speculation on the fall of rates which does not require an upfront capital, (Capo, 2008).

3. Corporate finance

The managers should advice the company to enter into a swap contract whereby they pay fixed rates and receive floating. In this case the managers should organize for a float rate payment and receive fixed rates so as to hedge against the interest rates, by doing so the company will be in a state where it will match the floating rates with assets or income flow. This helps the managers to the swap option to take which does not deviate much from the company’s asset.

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4. Risk management

 The Dorchester Inc. managers should be in a position to evaluate its counterparty that is due to enter into a contract with; this is due to huge risks involved due to a number of transactions taking place. The manager should advice appropriately on the risk involved in the fixed and floating interest rates exposure so as to avoid costs that can emerge due to remaining interest rates that were not cleared or were not offset during the contract. The managers can achieve this by assessing its ability to offset the floating rates as compared to its assets, (John , 2006).

4. Rate-locks on bond issuance

 The manager’s should take a crucial analysis concerning the option to take in order to avoid extra financial risks and costs. The company managers should decide when appropriate to issue the fixed rate bonds or the swaps contract by comparing the cost benefit analysis. When the managers will decide to issue the fixed rate bonds automatically they lock out the current interest rates by entering into a swap contract. When the management makes such decision they look for time to sell the bond through the broker and once they sell it, they exit the option of swap contract. also when the prices of the bond falls down the swap contract becomes more relevant thus making it  more viable to the company ,thus this will enable the company to offset its financial costs.

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Dorchester Inc. should settle on the vanilla swap because it is the most liquid interest rates which can be exchanged by fixed interest rate payment for floating rates to attain short term addition to this interest rate swaps has enabled most companies to manage , control and  settle their debts within a short period. This has made this derivative contract to grow into the most useful derivative in the world market.

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