Hara-Kiri Swaps

What are Hara-Kiri Swaps?

The Hara-kiri swaps were cross-currency financial instruments or interest rate swaps that were introduced in the 1980s to attract foreign investment in Japan.

Hara-Kiri swaps function just like regular swaps. The only difference is the aim and purpose behind the swaps. Other swaps are strategically offered to earn profit by speculating the variable interest rate at the time of final payment. 

The introduction of foreign business to any market comes with a lot of incentives. For example, a more competitive environment is formed, better technology is used to develop better products, etc. 

The primary aim of introducing this financial instrument was to boost foreign business in Japan.

Since the goal was to attract foreign business and not to earn a major profit on deals, the institution initiating the transaction would earn little to no profit on these transactions. 

Financial banks were not looking for monetary benefits through these swaps. Instead, they got indirect incentives like increased underwriting, credit, and insurance-related business.

On the other hand, foreign businesses offer Hara-Kiri swaps to attract them and make them invest in different market spheres to earn indirect incentives like a boost in insurance-related business.

These swaps were termed financial suicide back in the day. This is because the originator would receive very little monetary benefit. 

Hara-Kiri is a ritual practiced in Japan by samurai. They cut their belly to take their own lives. Because of similar traits and the nature of the Hara-Kiri swap contracts in the financial world, this swap contract was named after the ritual.

What are Swap Contracts?

Swap contracts are financial derivatives. So, fundamentally their value is derived from, or dependent on, another underlying asset or assets. 

A swap contract is a financial instrument where two parties are involved and exchange or ‘swap’ cash flows or assets in place of another within a specified period. 

One opts to pay a fixed rate of interest, and the other opts for a floating rate of interest or chooses an underlying asset (assets like the value of crude oil, steel, gold, etc.) that is predetermined.

It’s an offer where both parties speculate the value of the underlying asset, and whoever is correct in its predictions ends up being the profitable party.

Technically, amounts ascertained need to be ‘swapped.’ However, amounts are not swapped in most cases. Instead, the net amount is received by the party profiting from the transaction. There are various swap contracts like interest rate, currency, commodity, total return, and credit default swaps. 

The most common swap contracts are interest rate swaps and currency swaps.

Interest Rate Swaps

In such swap contracts, a principal amount, settlement date, settlement period, and other contract terms are predetermined. If two parties are involved, one party will opt for a fixed interest rate, and the other will opt for a variable interest rate that changes over time. 

Now, one party will pay its fixed interest rate while the other will pay the variable interest rate. So, for instance, two companies, X and Y, will contract on 1st April 2020 (settlement date) for three years (settlement period). 

They chose their principal amount to be $20,000. Now, company X chooses a fixed rate of interest, say 5%. On the other hand, company Y chooses a floating rate of interest, like LIBOR.

Now, if at the end of the year, i.e., 1st April 2021, the LIBOR is at 4%, Company X will be liable to pay an interest of 5% over $20,000, equivalent to $1000 to Company Y.

On the other hand, Company Y will be liable to pay 4% interest over $20,000, totaling $800, to Company X.

Instead of swapping the actual interest amounts, the profitable party will receive a net amount from the other party. In this case, instead of swapping the amounts, Company X will end up paying $200 to Company Y.

Foreign Currency Swap

Unlike interest rate swaps, the principal amount decided between the parties exchanges hands. Here, both parties exchange the principal amount, as the other currency is needed by the party to conduct business in the other country. This is why these swaps occur in the first place. 

Another difference between foreign currency and interest rate swaps is that both parties are given a fixed rate of interest based on the foreign currency the parties have borrowed.

For instance, if Company A (a Europe-based company) needs $20,000 and, therefore, enters into a foreign currency swap with Company B (an America-based company) with a promise of giving 16,000 Euros (as the exchange rate is, let’s say, 1 dollar = 0.80 Euro) on 1st April 2020. 

Both companies will predetermine the interest rate, say 5% for Company A and 3% for Company B.

At the end of the year, i.e., 1st April 2021, Company A, since it had borrowed dollars, is liable to pay the interest in dollars. This is equal to $1000 (5% of $20,000) for Company B. On the other hand, Company B will be liable to pay 480 euros (3% of 16,000 Euros).

In case there has been a change in the exchange rate of the two currencies after one year, then interest payments will be made based on the new exchange rate.
Once the settlement period has ended, the initial principal amount is exchanged again, irrespective of what the exchange rate is at the time.

What is LIBOR?

LIBOR is an abbreviation for the London Interbank Offer Rate. It is a reference rate usually used for unsecured short-term borrowings. It is also a reflection of the financial position of central banks. It determines the floating interest rate in interest rate swaps, currency rate swaps, etc. 

The Intercontinental Exchange governs the LIBOR. It is calculated for five currencies: the Swiss franc, Japanese yen, US dollar, euro, and pound sterling. The rates of each currency are computed with the assistance of 11-18 banks.

Suppose, in a swap contract with a settlement period of 6 months, a party has opted for LIBOR as a reference for its floating interest rate. The interest rate amount will be calculated after six months with the help of the LIBOR rate at the time.

Earlier, LIBOR was computed by the British Bankers Association (BBA). However, during the financial crisis of 2008, the rigging and manipulation by the authority in setting the LIBOR rate were discovered. With the help of several committees, a new administration team called the Intercontinental Exchange (ICE) was formed, taking control in 2014.

First Formal Swap Contract

The first swap contract was formalized in 1981 between the World Bank and IBM. This example also reflects the use of swap contracts perfectly. The World Bank needed German marks and Swiss francs to finance its operations. 

However, the Swiss and German governments had imposed restrictions that made it difficult for the World Bank to borrow money from their economy. Conveniently, IBM had borrowed these currencies in advance when the restrictions on borrowing activities did not exist. 

At that time, IBM needed US dollars when interest rates imposed on corporate companies for borrowing were very high. Ultimately, Salomon Brothers came to the rescue of both IBM and the World Bank by recommending the parties swap their debts.

IBM helped the World Bank by supplying them with the francs and marks IBM had. On the other hand, the World Bank offered them US dollars in return. Both parties gained from the transaction, and since then, the frequency of swap contracts has increased drastically. The market has grown and now accounts for trillions per year in agreements. 

Swaps Vs. Futures

Futures, like swaps, are also financial derivatives. A futures contract mandates a buyer to buy and a seller to sell an underlying asset at a predetermined price and date. Again, like swaps, these underlying assets can be commodities or financial instruments.

Traditionally, swaps were traded over the counter. However, futures are always traded in a standardized manner. The standardization makes the transaction more secure for both parties. 

The transactions are even more secure, and the default rate is low as transactions are governed by clearing houses to ensure mistakes are not made by each party. Futures are settled daily, and margin calls are also made as a reminder to update the account as per the margin requirements. 

Like many other financial instruments, futures are also used to make a profit or hedge risks.

•  In swaps, the parties involved swap the cash flows at a predetermined date after a specified period. On the other hand, futures makes it compulsory for a buyer to buy and a seller to sell a financial or physical asset on a predetermined date.
•  Futures are exchange-traded and historically are more standardized. For example, swaps were standardized only in 2020, before which they were traded over the counter.
•  Swaps are more customizable. The contract terms are more adjustable according to the priorities of both parties, as they are traded over the counter via the network of brokers and dealers.
•  Futures contracts require margins to be maintained. If the trader makes any fault on their part, margin calls are made, and the account will need to be reimbursed for clearing the margins. No margin calls exist in swap contracts.

Swap Contracts Advantages

Swap contracts do not provide anyone with any additional advantage. However, they become one of the most useful financial instruments in some circumstances.

Commercial Needs

Sometimes, an organization's business operations are such that certain swap contracts help them maintain a certain interest rate, currency, or commodity. This lets them analyze and ascertain their financial position.

For instance, if a bank is receiving a fixed interest rate on its loans but is paying a floating interest rate for its borrowings, it can cause a lot of confusion in determining its returns.

In this scenario, a bank can enter into a fixed-pay swap. A fixed-pay swap is a derivative in which a party can swap its fixed interest rate on loans with someone's floating rate.

This would result in the bank only dealing with the floating interest rate on its assets (loans) and liabilities (borrowings).

Comparative Advantage

This refers to producing a product or service at a price lower than competitors. For example, swap contracts can provide advantages to businesses that require foreign currency and are willing to swap it with their national currency.

The first formalized swap contract (between World Bank and IBM) also provided both parties a comparative advantage. For instance, if a United-States-based company wants to extend its operation in Europe and requires euros. 

It is more accessible to source funds in the US than in Europe, as these contracts are relatively popular in the United States. Using foreign currency swaps, they can exchange their dollars with euros and continue expanding their European operations. 

Sourcing through swap contracts in the United States for them will be more convenient and economically viable than sourcing funds in Europe. Therefore, swap contracts will provide them with a comparative advantage. 

Summary

Hara-Kiri swaps were a very innovative financial tool that the Japanese started using in the 1980s before the World Trade Organization forced every country to open trade barriers and let foreign businesses break their geographical boundaries. 

However, the commencement of the globalization era led to the death of Hara-Kiri Swaps, as now other countries have various other incentives to enter foreign markets. Moreover, the constant loss-incurring proposition was not lucrative for the originator of the swap.

Businesses started trading in swap contracts in the 1970s-1980s. This was the beginning of such transactions. The market of swap contracts overall has only grown ever since, now at trillions of dollars a year in size.

Hara-Kiri swaps are not used anymore at the frequency they were in the 1980s. However, due to growth in the size of the swaps market, swap contracts have also been standardized and are now traded on formal exchange networks, just like futures.

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