The Swap Mechanism

The advantage of a swap transaction is to alter an exposure (of a corporate for example) in a particular currency to a one that is more suited to its cash flows (for payments to domestic creditors or meeting import obligations) and risk - reward perception (depending on the strength / volatility of one currency over the other). The swaps are generally associated with a premium or a discount depending on the benchmark interest rate for the two currencies. Normally, the rates considered are the risk- free government bond rates. Assume we are doing a yen-dollar swap.Now, the benchmark yield for yen is about 4 per cent and for the dollar it is about 6 per cent. The dollar swap would carry a premium of about 8 per cent which can be broken up into 6 per cent for the yields foregone and 2 per cent to cover the margin and compensation for the counterparty risk taken.

Arbitrage is a transaction wherein the arbitraguer locks on to a riskless profit avenue which basically arises from either price disequilibrium or.market distortions.