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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 thelegs 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 a floating interest
rate, foreign exchange rate, equity price, or commodity price.
The cash flows are calculated over a notional principal amount. Contrary to a future,
a forward or an option, the notional amount is usually not exchanged between counterparties.
Consequently, swaps can be in cash or collateral.
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.[3] 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

Types of swaps[edit]
The five generic types of swaps, in order of their quantitative importance, are: interest rate
swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other
types of swaps.

Interest rate swaps[edit]

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating.
By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for
their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a
separate swap with a financial intermediary such as a bank. In return for matching the two parties together,
the bank takes a spread from the swap payments.

The most common type of swap is a "plain Vanilla" interest rate swap. It is the exchange of
a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years.
The reason for this exchange is to take benefit from comparative advantage. Some companies may
have comparative advantage in fixed rate markets, while other companies have a
comparative advantage in floating rate markets. When companies want to borrow, they look
for cheap borrowing, i.e. from the market where they have comparative advantage. However,
this may lead to a company borrowing fixed when it wants floating or borrowing floating when

it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed
rate loan into a floating rate loan or vice versa.
For example, party B makes periodic interest payments to party A based on a variable interest
rate of LIBOR+70 basis points. Party A in return makes periodic interest payments based on a
fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is
called variable because it is reset at the beginning of each interest calculation period to the
then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is
slightly lower due to a bank taking a spread.

Currency swaps[edit]
Main article: Currency swap
A currency swap involves exchanging principal and fixed rate interest payments on a loan in
one currency for principal and fixed rate interest payments on an equal loan in another
currency. Just like interest rate swaps, the currency swaps are also motivated by comparative
advantage. Currency swaps entail swapping both principal and interest between the parties,
with the cashflows in one direction being in a different currency than those in the opposite
direction. It is also a very crucial uniform pattern in individuals and customers.

Commodity swaps[edit]
Main article: Commodity swap
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged
for a fixed price over a specified period. The vast majority of commodity swaps involve crude
oil.

Subordinated risk swaps[edit]


A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity
holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks.
These can include any form of equity, management or legal risk of the underlying (for example
a company). Through execution the equity holder can (for example) transfer shares,
management responsibilities or else. Thus, general and special entrepreneurial risks can be
managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC)
and there are only a few specialized investors worldwide.

Other variations[edit]
There are myriad different variations on the vanilla swap structure, which are limited only by
the imagination of financial engineers and the desire of corporate treasurers and fund
managers for exotic structures.[1]

A total return swap is a swap in which party A pays the total return of an asset, and party B
makes periodic interest payments. The total return is the capital gain or loss, plus any interest
or dividend payments. Note that if the total return is negative, then party A receives this

amount from party B. The parties have exposure to the return of the underlying stock or
index, without having to hold the underlying assets. The profit or loss of party B is the same for
him as actually owning the underlying asset.
An option on a swap is called a swaption. These provide one party with the right but not the
obligation at a future time to enter into a swap.
A variance swap is an over-the-counter instrument that allows one to speculate on or hedge
risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser
to fix the duration of received flows on a swap.
An Amortising swap is usually an interest rate swap in which the notional principal for the interest
payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a
mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those
customers of banks who want to manage the interest rate risk involved in predicted funding
requirement, or investment programs.
A Zero coupon swap is of use to those entities which have their liabilities denominated in
floating rates but at the same time would like to conserve cash for operational purposes.
A Deferred rate swap is particularly attractive to those users of funds that need funds
immediately but do not consider the current rates of interest very attractive and feel that the
rates may fall in future.
An Accrediting swap is used by banks which have agreed to lend increasing sums over
time to its customers so that they may fund projects.
A Forward swap is an agreement created through the synthesis of two swaps differing in
duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred
to as a forward start swap, delayed start swap, and a deferred start swap.

Valuation[edit]
Further information: Rational pricing Swaps and Arbitrage
The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is
worth zero when it is first initiated, however after this time its value may become positive or
negative.[1] There are two ways to value swaps: in terms of bond prices, or as a portfolio
of forward contracts.[1]

Using bond prices[edit]


While principal payments are not exchanged in an interest rate swap, assuming that these are
received and paid at the end of the swap does not change its value. Thus, from the point of
view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate
bond (i.e. receiving fixed interest payments), and a short position in a floating rate
note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite
positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows
correspond to those in the swap. Thus, the home currency value is:
, where
swap,

is the domestic cash flows of the

is the foreign cash flows of the LIBOR is the rate of interest offered by banks

on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for
1-month deposits, 3-month LIBOR for three months deposits, etc.
LIBOR rates are determined by trading between banks and change continuously as economic
conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is
a reference rate of interest in the international market.

Arbitrage arguments[edit]
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the
NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be
possible.
For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a
fixed rate, and Party B pays a floating rate. In such an agreement the fixed ratewould be such
that the present value of future fixed rate payments by Party A are equal to the present value
of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the
case, an Arbitrageur, C, could:

1.assume the position with the lower present value of payments, and borrow funds equal to
this present value
2.meet the cash flow obligations on the position by using the borrowed funds, and receive the
corresponding payments - which have a higher present value
3.use the received payments to repay the debt on the borrowed funds
4.pocket the difference - where the difference between the present value of the loan and the
present value of the inflows is the arbitrage profit.
Subsequently, once traded, the price of the Swap must equate to the price of the various
corresponding instruments as mentioned above. Where this is not true, an arbitrageur could
similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly
priced instrument, pocket the difference, and then use payments generated to service the
instrument which he is short.