Hara-Kiri swaps were interest rate or cross-currency financial instruments that were popular in Japan in the 1980s to attract foreign investment into the country. The intention of the originator was solely to obtain foreign business and not to earn a profit. The demand decreased as foreign investment was allowed into the country, and hence their purpose of attracting foreign investment was defeated.
The term Hara-Kiri is a Japanese ritual of slow suicide by shameful warriors. The term was used in finance to depict that not making a profit on such types of instruments is financial suicide for the organization.
A Hara-Kiri swap was introduced by Japanese investors to attract foreign investors into the country, which was their objective over return on investment.
The Japanese economy received a good amount of foreign investment because of the Hara-Kiri swaps. However, their popularity went down once the Japanese economy was opened to the world.
A swap contract helps institutions match their assets with their liabilities. The asset being the loans given to borrowers, and the liabilities being the deposits made by customers for which they expect a return.
How Did Hara-Kiri Swaps Help the Japanese Economy?
The Hara-Kiri swaps don’t provide any direct benefits to the issuer. Instead, they provide indirect benefits. The foreign entity will most likely deal with a financial institution, which will increase the underwriting, credit, and insurance businesses of the institution.
Advantages of a Swap
A swap is generally less expensive than other financial instruments. They are used to protect investors from future risks for the swap period.
Swaps can go on for years compared to forwards and futures. Swaps also help companies to maintain their Asset Liability Management (ALM) by keeping their assets and liabilities the same.
Disadvantages of a Swap
A swap is beneficial for the long term. If a swap is canceled early, there is a fee incurred.
A swap is an illiquid financial instrument, and it is subject to default risk.
Swaps vs. Futures
A futures contract is an agreement between a buyer and a seller to deal in a certain commodity at a predetermined price and a predetermined date. A swap contract, on the other hand, is an arrangement between two parties to swap the gains or losses on a certain commodity.
For example, Party A and Party B enter into a swap contract. Party A is trading at a fixed interest rate of 6%, while Party B is holding a variable interest rate swap that is linked to LIBOR (London Interbank Offered Rate).
Party A expects interest rates to go down, while party B expects the interest rates to go up. Six months down the line, the LIBOR goes down to 4%. In such a case, Party A wins, and Party B is expected to pay the former. The way it works is the party losing in the contract pays the winner only the net. It means Party B pays Party A only 2%.
The benefit of a swap is that it helps investors to hedge their risk. Had the interest rates gone up to 8%, then Party A would be expected to pay party B a net of 2%. The downside of the swap contract is the investor could lose a lot of money.
Below are the two features of a swap contract:
A swap contract should include a start date and an expiry date, and both parties need to ensure that they adhere to the terms and conditions of the contract.
The parties also need to decide on the terms of the contract – for example, if the losing party only pays the net amount to the other party or if both parties swap cash flows. They also need to decide if the cash flows are going to be paid monthly, quarterly, or annually.
How Does a Swap Contract Work?
Apple and Microsoft enter into a swap contract with a nominal value of $1 million and a maturity of 1 year. Apple pays a fixed interest rate of 5%, while Microsoft pays a variable rate based on LIBOR. The contract states that the losing party pays only the net amount to the winning party annually.
On maturity, the interest rate prevailing in the market is 4%. Since Apple was expecting the interest rates to fall and entered into the contract, Microsoft will be expected to pay Apple a net of 1% or $10,000.
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