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What is a Debt Swap?

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  • Written By: Mary McMahon
  • Edited By: O. Wallace
  • Last Modified Date: 30 August 2016
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A debt swap is a financial transaction in which one person or entity swaps debt with another. There are a number of types of swaps which can occur in the financial world beyond debt swaps, including currency swaps, interest rate swaps, debt/equity swaps, and credit default swaps. The purpose of all such transactions is to make a profit on some aspect of the transaction. These transactions are often facilitated through an intermediary such as a bank, since they can be difficult for the parties involved to coordinate on their own.

One example of a debt swap is a swap which may be used to provide financial assistance to a struggling nation. In this case, a rescuing nation or agency like the World Bank will arrange a debt swap in which it acquires debt from the struggling nation at a discount in order to convert the debt to equity in the local currency. Debt/equity swaps of this nature are very common tools for rescuing countries in debt.

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Corporations can use debt swaps when they restructure. In a debt/equity or equity/debt swap, shareholders or creditors of a corporation can be provided with an incentive to trade their equity for debt such as bonds, or to trade their debt for equity such as stocks. In the process, the company's financial situation is shifted, which can rescue it from financial problems or allow it to make a merger or to engage in other business activities. Usually, the deal is sweetened. For example, when shareholders are asked to swap their shares for bonds, it will not be done at a one-to-one ratio, because this provides no incentive to swap.

Another type of debt swap is utilized in conservation activities. In a debt for nature swap, a nation agrees to swap preservation of the natural environment for some of its debt. This benefits the nation because it brings its overall debt level down, and it benefits the environment by creating more protected habitat for animals and plants. Debt for nature swaps may be organized by conservation organizations or by governmental organizations concerned with environmental preservation.

Debt swaps were developed in the 1980s, along with a range of other financial products. In the 2000s, some of these financial products proved to be faulty. Credit default swaps, for example, proved to be part of the confluence of circumstances which led to the 2008 financial crisis. Financial regulators proposed a tightening on debt swaps and similar products with the goal of preventing similar problems in the future while still allowing people to trade financial products.

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pleonasm
Post 3

@indigomoth - I bet it runs into the same problem that I've found whenever my friends attempt to do something like that. Once you've put all your debt eggs into a single basket, you have to really make an effort to live frugally and within your own means, or you will end up in a worse condition.

Because you will get to the point where you need to take out another loan and all the other places where you borrowed money before consider you to have paid them off and are willing to lend you even more now.

A credit debt swap is only going to work if the attitudes that got the person, or country, into debt into the first place are changed and they are able to really work on getting their debt down. Otherwise, it's only going to exacerbate the problem in the long run.

indigomoth
Post 2

@Mor - The problem with that kind of debt swap is that it's so difficult to define and draw up a contract that is actually going to work in the long run. It's not a matter of the country sitting back and not doing anything. Much environmental degradation is happening illegally, or at least without government regulation, so in order to stop it, they'd need to be active in preserving the environment. It's not like keeping money in a bank. If they slip up in a serious way (for example, a forest fire), the environment can't be brought back.

And from what I understand that kind of deal isn't common, as the groups who are interested in making it don't always

have that kind of purchasing power.

More often a debt swap for a developing country is similar to the kind that you can do as an individual, where you get a single company to buy out all your debt so that you are paying a lower interest rate.

Mor
Post 1

Debt for nature swaps are actually an amazing deal for the country which is in debt. Because, not only do they get to repay some of their loan for doing essentially nothing, they will also keep more of their environment intact.

And what more and more countries are realizing is that the best way to get money into the country is to increase tourism, which can be done through showcasing an amazing environment. The mountain gorillas of Uganda are a great example. They are bringing in more money and providing more jobs as tourist attractions than they ever did as bushmeat or trophies.

So, preserving the environment makes financial sense for more reasons than just because it will clear off debt and any country that has that choice would be wise to take it.

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