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Swap (finance)
From Wikipedia, the free encyclopedia

In finance, a swap is a derivative in which two counterparties exchange certain benefits 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. Specifically, the 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 calculated.[1] Usually at the time when the contract is initiated at least one of these series of
cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange
rate, equity price or commodity price.[1]

The cash flows are calculated over a notional principal amount, which is usually not exchanged
between counterparties. Consequently, swaps can be used to create unfunded exposures to an
underlying asset, since counterparties can earn the profit or loss from movements in price without
having to post the notional amount 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.

The first swaps were negotiated in the early 1980s.[1] David Swensen, a Yale Ph.D. at Salomon
Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall
of Long-Term Capital Management" by Roger Lowenstein. Today, swaps are among the most
heavily traded financial contracts in the world.[citation needed]

Contents

1 Swap market

2 Types of swaps

2.1 Interest rate swaps

2.2 Currency swaps

2.3 Commodity swaps

2.4 Equity Swap

2.5 Credit default swaps

2.6 Other variations

3 Valuation

3.1 Using bond prices

3.2 Using forward rate agreements

3.3 London Interbank Offered Rate (LIBOR)

3.4 Arbitrage arguments

4 See also

5 References

6 External links

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 Holdings
Inc., the largest U.S. futures market, the Chicago Board Options Exchange,
IntercontinentalExchange and Frankfurt-based Eurex AG.

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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 product—which 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:

The CDS and currency swap markets are dwarfed by the interest rate swap
market. All three markets peaked in mid 2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008

Notional outstanding
in USD trillion
Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1]
(http://www.bis.org/publ/otc_hy0505.htm), "OTC Derivatives Market Activity in the Second Half of 2006", BIS,
[2] (http://www.bis.org/publ/otc_hy0705.pdf)

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total
return of a swap, an economic statistic, etc. The most important criterion is that it comes from an
independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the
British Bankers Association, an independent trade body.

Types of swaps

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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.

Interest rate swaps

Main article: Interest Rate Swap

The most common type of swap A is currently paying floating, but wants to pay fixed. B is currently
is a “plain Vanilla” interest rate paying fixed but wants to pay floating. By entering into an interest
swap. It is the exchange of a rate swap, the net result is that each party can 'swap' their existing
fixed rate loan to a floating rate obligation for their desired obligation. Normally the parties do not
loan. The life of the swap can swap payments directly, but rather, each sets up a separate swap with
range from 2 years to over 15 a financial intermediary such as a bank. In return for matching the
two parties together, the bank takes a spread from the swap
years. The reason for this
payments.
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 turn 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

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 also are motivated by comparative advantage.

Commodity swaps

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.

Equity Swap

Main article: equity swap

An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket
of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to
pay anything up front, but you do not have any voting or other rights that stock holders do have.

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Credit default swaps

Main article: Credit default swap

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of
payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or
loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be
a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded.
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return,
receives a sum of money if one of the events specified in the contract occur.

Other variations

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, i.e. volatility, of some underlying product,
like an exchange rate, interest rate, or stock index.

A constant maturity swap, also known as 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 LIBOR.

Valuation
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

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 can be regarded as 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):

Vswap = Bfixed − Bfloating

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

Vswap = Bfloating − Bfixed

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:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the
swap, Bforeign is the foreign cash flows of the swap, and S0 is the spot exchange rate.

Using forward rate agreements

Consider a three year interest rate swap with semiannual payments. The first cash flow is known at
the time the swap is initiated, however the other five exchanges can be regarded as forward rate
agreements. The payment for these other exchanges is the 6 month rate observed in the market 6
months earlier. Assuming that forward interest rates are realised, this method values the swap by
firstly calculating the required forward rates using the LIBOR/swap curve, then calculating the swap
cash flows using these rates, and then finally discounting these cash flows back to today.

London Interbank Offered Rate (LIBOR)

Main article: London Interbank Offered Rate

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

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 rate would 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

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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.

See also

Constant maturity swap

Credit default swap

Cross currency swap

Equity swap

Foreign exchange swap

Fuel price risk management

Interest rate swap

Total return swap

Variance swap

Yield curve

References

Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006

1. ^ a b c d e f John C Hull, Options, Futures and Other Derivatives (6th edition), New Jersey: Prentice Hall,
2006, 149

External links

swaps index (http://www.quantnotes.com/fundamentals/swaps/index.htm), quantnotes.com

swaps-rates.com (http://www.swap-rates.com/), interest swap rates statistics online

Bank for International Settlements (http://www.bis.org/)
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Categories: Derivatives

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