Swap Ratio

Swap is an agreement between two entities. The conditions of the exchange and details of the transaction are set in the swap transaction. Swaps are divided into many categories and can be classified differently according to criteria.

Swap Ratio is an exchange rate in corporate finance. In this process it is the exchange rate of shares of the merged companies. A purchase transaction does not have to be made in cash only. Actions can be gradually converted and for this, we use the necessary factors. There are indicators that show the number of shares that the acquiring company must issue for each target company. There is no specific formula for calculating the ratio in specific situations. It depends on many variables.

Calculating the Swap factor is a necessary thing to create a process. Values such as:

• company size,
• earnings per share,
• bookvalue,
• strategic factors

are needed to calculate the swap ratio.

The main ratio used in the swap ratio refers to the time in which the shareholders of the company being acquired receive the shares of the buying company. This shows the strength and size of the two companies. Of course, if during the exchange one company has to offer a larger number of shares in exchange for one share, it is assumed that the offering company is less efficient. While the whole enterprise is being carried out so that in the future two companies will bring much greater value-added than before the merger.

Exchange Process

For example, if company A acquires company B and offers a 1: 3 conversion ratio, it will issue one share of its own company (company A) for every three shares of company B that will be taken over. If enterprise B has 6 outstanding equity interests and all of them is acquired by enterprise A, then enterprise A will issue 2 new equity interests in company A. To calculate the exchange rate, we take the offer price and divide it by the buying company's share price.

The valuation of the buying company unit becomes more complex at the time of purchase. The main reason for this is the decrease in the purchasing power of the buying company. Company units before buying are stronger than after. After completing the transaction units are divided into two companies.

The swap ratio gives investors two companies the assurance that the investment will remain unchanged both before and after the transaction. This is extremely important because during the whole process two companies are compared in many respects. The basic application of this factor is the complete elimination of the fraudulent takeover of assets. This situation cannot take place because the factor presented before the transaction remains unchanged even after.

Examples of Swap Ratio

1. Interest Rate Swap: An interest rate swap is an agreement between two parties to exchange a series of fixed interest payments for a series of floating interest payments. The parties will decide on the amount of cash flows to be exchanged and the length of time the swap will last.
2. Currency Swap: A currency swap is an agreement between two parties to exchange a certain amount of one currency for another. The two parties will agree upon the exchange rate, the amount of currency to be exchanged, and the length of the swap.
3. Equity Swap: An equity swap is an agreement between two parties to exchange a series of equity payments for a series of cash payments. The terms of the swap may involve the exchange of a single stock or a basket of stocks.
4. Commodity Swap: A commodity swap is an agreement between two parties to exchange a series of commodities for a series of cash payments. The terms of the swap will involve the exchange of a single commodity or a basket of commodities.
5. Credit Default Swap: A credit default swap is an agreement between two parties to exchange a series of payments in the event of a credit event, such as a default on a loan or bond. The terms of the swap will involve the exchange of credit protection from one party to another.

Advantages of Swap Ratio

Swap ratio is a type of financial transaction that enables two parties to exchange their assets for mutual benefit. It is usually used to hedge against risks and to manage liquidity. The main advantages of a swap ratio include:

• Reduced Risk: Swap ratio helps to reduce risk by providing a fixed exchange rate that is agreed upon in the swap agreement. This helps to limit the potential volatility in the market and provides a hedge against adverse price movements.
• Cost Savings: Swap ratio can be used to reduce the cost of a transaction, as the parties involved can negotiate a more favorable exchange rate than would otherwise be available in the open market.
• Flexibility: Swap ratio also provides flexibility and may be used to adjust the terms of the transaction if needed. This can be beneficial in scenarios where the market conditions are changing and a more favorable exchange rate is available.
• Access to New Markets: Swap ratio can also be used to gain access to new markets, as the parties involved in the swap can negotiate a rate that is beneficial to both parties. This can be beneficial for companies that are looking to expand into new markets or diversify their investments.

Limitations of Swap Ratio

Swap ratios are a tool used to determine the relative value of two different assets that are being exchanged. However, there are certain limitations associated with swap ratios that must be considered when entering into a swap agreement. These limitations include:

• Lack of liquidity: Swap ratios are based on the current market prices of the assets being exchanged, which can be difficult to accurately determine if the assets do not have enough liquidity in the market.
• Volatility: The prices of the assets being exchanged can be highly volatile and change rapidly, which can make it difficult to accurately set the swap ratio.
• Counterparty risk: The swap ratio must take into account the creditworthiness of the counterparty, as the counterparty could default on the swap agreement.
• Regulatory restrictions: Depending on the jurisdiction, there may be certain regulatory restrictions that limit the types of swaps that can be entered into and the terms that can be included.
• Complexity: Swaps can be complex financial instruments that require a thorough understanding to enter into.

Other approaches related to Swap Ratio

Swap ratio is an important part of a swap agreement and is used to calculate the exchange rate of assets in a swap. There are several approaches that can be used to determine the swap ratio, including:

• Relative Value: This approach uses the relative value of the assets involved in the swap to determine the exchange rate. It looks at the current and expected future values of the assets and compares them to determine the swap ratio.
• Comparable Transactions: This approach uses data from past transactions to calculate the swap ratio. It looks at similar transactions in the market and uses them to estimate the exchange rate of the assets.
• Negotiated Agreement: This approach uses negotiation between the parties involved in the swap to determine the exchange rate. This can be used if the other approaches do not provide an accurate exchange rate for the assets.

In summary, there are several approaches that can be used to determine the swap ratio, including relative value, comparable transactions, and negotiated agreement. Each approach has its own merits and drawbacks, and the most appropriate approach should be chosen depending on the situation.

Footnotes

Swap Ratio — recommended articles

Commodity swap — Currency certificate — Embedded derivative — Asset swap — Collateral management — Incremental borrowing rate — Asset-swap spread — Interest Rate Collar — Contingent consideration

References

• Buetow G.W., Fabozzi F.J., (2000), Valuation of Interest Rate Swaps and Swaptions, John Wiley & Sons, United States of America.
• Chatterji S., Hedges P., (2002), Loan Workouts and Debt for Equity Swaps: A Framework for Successful Corporate Rescues, John Wiley & Sons, England.
• Flavell R.R., (2010), Swaps and Other Derivatives, John Wiley & Sons, United Kingdom.
• Padmalatha S. Paul J., (2011), Management Of Banking And Financial Services, 2/E, Pearson, India.
• Ray K. G., (2010), Mergers and Acquisitions : Strategy, Valuation and Integration, PHI Learning Pvt. Ltd, New Delhi.

Author: Kacper Chmarzyński