SWAPS

In finance, a swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds. Specifically, two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as an rate, foreign, equity price, or commodity price. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more thn $348 trillion in 2010, according to Bank for International Settlements (BIS).

Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange, the largest U.S. futures market, the Chicago Board Options Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG. The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world productwhich is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as:

CHARACTERISTICS OF SWAP CONTRACTS Swaps are derivative securities in the form of agreements between two counterparties to exchange cash flows over a period of time, depending on the values of specified market variables.

Counterparties. The parties that agree to the swap. Because the swaps market has virtually no governmental regulation, participation in the swaps market is effectively limited to firms and institutions that either engage in frequent swap transactions or have access to major swap facilitators. Notional principal. An amount used as a base for computations, but not an amount that is actually transferred from one party to another. Pay fixed. In a plain vanilla interest rate swap, one counterparty agrees to pay a sequence of fixed-rate interest payments and to receive a sequence of floating-rate interest payments. This counterparty is said to have the pay-fixed side of the deal. Receive fixed. The counterparty with the receive-fixed side of the deal agrees to receive a sequence of fixed-rate interest rate payments and to pay a sequence of floating-rate payments.

Tenor. The tenor of a swap transaction refers to the specified time period over which periodic net interest payments will be made between the counterparties TWO BASIC MOTIVATIONS FOR ENTERING INTO A SWAP AGREEMENT Commercial needs The normal commercial operations of some firms naturally lead to interest rate and currency risk positions of a certain type. For example, a typical savings and loan association accepts deposits and lends those funds for long-term mortgages. Since depositors can withdraw their funds on short notice but most mortgagors wish to borrow at a fixed rate for a long time, the savings and loan association can be left with floating rate liabilities and fixed rate assets. If interest rates rise, it will be forced to increase the rate it pays on deposits but it cannot increase the interest rates on the mortgages that have already been issued. Comparative advantage In many situations, one firm may have better access to the capital market than another firm. For example, Party A may be able to borrow in U.S. dollars cheaper while Party B may

be able to borrow cheaper in German Deutschmark. This raises the possibility that each firm can exploit its comparative advantage and share the gains by reducing overall borrowing costs. Consider the following example. The borrowing rates for firms A and B in different currencies are as follows

In this case, B has an advantage in the U.S. market over A while A has an advantage over B in the Netherlands. Since swaps are specifically tailored to individual counterparties, the secondary market for them is quite illiquid and any changes to the contract require negotiation between the two counterparties LIMITATIONS OF THE SWAPS MARKET ARE:

It can be difficult to locate a counterparty to take the opposite side of the transaction. Swaps cannot be altered or terminated early without the agreement of both parties.

However, the fact that the swaps market provides privacy not available in exchange trading is considered a benefit by many participants. THE ADVANTAGES OF SWAPS ARE AS FOLLOWS: 1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs. 2) Swap can be used to hedge risk, and long time period hedge is possible. 3) It provides flexible and maintains informational advantages. 4) It has longer term than futures or options. Swaps will run for years, whereas forwards and futures are for the relatively short term. 5) Using swaps can give companies a better match between their liabilities and revenues. The disadvantages of swaps are: 1) Early termination of swap before maturity may incur a breakage cost. 2) Lack of liquidity. 3) It is subject to default risk