4. Use an exchange option: A swapist is an option for a swap. Purchasing a swap would allow a party to set up a potentially compensatory swap at the time of execution of the initial swap, but not to enter into it. This would reduce some of the market risks associated with Strategy 2. This uniform approach to the agreement is an integral part of the structure and part of the network-based protection offered by the framework agreement. The fact that all transactions are the sole contract enhances the ability to close these transactions and obtain a one-time net amount payable in the event of default. As with interest rate swaps, payments are effectively reduced against each other relative to the exchange rate that prevailed at the time. If the one-year exchange rate is $1.40 per euro, the payment by Company C is $1,960,000 and the payment of Company D would be $4,125,000. In practice, Company D would have the net difference of $2,165,000 ($4,125,000 – $1,960,000) to Company C.
To keep it simple, we say that they make these payments every year, starting one year from the exchange of capital. Since C borrowed the euro, it must pay interest in euros on the basis of an interest rate in euros. Similarly, Company D, which has borrowed dollars, will pay interest in dollars on the basis of a dollar interest rate. For this example, say, the agreed dollar interest rate is 8.25 per cent, and the euro-denominated interest rate is 3.5 per cent. For example, Company C pays 40,000,000 euros each year – 3.50% – 1,400,000 euros to company D. Company D pays the company C 50,000,000 – 8.25% – 4,125,000 dollars. The framework contract allows the parties to calculate their net financial commitment in over-the-counter transactions, i.e. a party calculates the difference between what it owes to a counterparty under a master contract and what the consideration owes under the same agreement.
The framework contract also helps to reduce litigation by providing significant resources that define its contractual terms and explain the intent of the contract, thus preventing litigation from beginning and providing a neutral resource for interpreting standard contractual terms. Finally, the framework agreement provides significant assistance in managing risks and credit for the parties. The first interest rate swap took place in 1981 between IBM and the World Bank. Yet, despite their relative youth, swaps have exploded in popularity.