Companies enter into swaps for reasons of return and/or risk

Either they wish to lower the cost of their financing or better match their financing to the cash flows from their operations, thereby providing some hedging. Each of the three types of swaps usually lowers the cost of financing. In addition each changes the company’s risk exposure:

a. A basis swap? A basis swap is an exchange of loan obligations based on different underlying reference rates. A company can reduce its financing risk if it can match the basis of its financing to the characteristics of its income stream.

b. A fixed-floating swap? A fixed-floating swap is an exchange of loan obligations where one is at a fixed rate and the other at a floating rate of interest. A company can reduce its financing risk if it can match its interest rate exposure to the characteristics of its income stream.

c. A currency swap? A currency swap is an exchange of loan obligations where the interest payments, principal payments, or both are denominated in different currencies. A company can reduce its financing risk if it can match its foreign currency exposure to the characteristics of its income stream.