An Introduction to Swaps

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In finance, a swap is a derivative in which 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 (or coupon) payments associated with the bonds. 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. 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. The cash flows are calculated over a notional principal amount, which 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. 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 thаn $426.7 trillion in 2009, according to International Swaps and Derivatives Association (ISDA).

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, 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 product—which is also a cash-flow

the net result is that each party can 'swap' . Types of swaps The five generic types of swaps. Credit swaps. at least one of the legs has a rate that is variable. in order of their quantitative importance. Currency swaps. 3. The most important criterion is that it comes from an independent third party. are: 1. By entering into an interest rate swap. For instance. but wants to pay fixed. an independent trade body. etc.measure. an economic statistic. Interest rate swaps A is currently paying floating. to avoid any conflict of interest. 2. Usually. the total return of a swap. There are also many other types of swaps. It can depend on a reference rate. B is currently paying fixed but wants to pay floating. Commodity swaps 5. 4. Equity swaps. LIBOR is published by the British Bankers Association. Interest rate swaps.

However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. In return for matching the two parties together.e. Currency swaps entail swapping both principal and interest between the parties. The life of the swap can range from 2 years to over 15 years. from the market where they have comparative advantage. party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. The reason for this exchange is to take benefit from comparative advantage. Party A in return makes periodic interest payments based on a fixed rate of 8. 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. such as LIBOR. It is the exchange of a fixed rate loan to a floating rate loan. The first rate is called variable. In reality. the currency swaps are also motivated by comparative advantage. each sets up a separate swap with a financial intermediary such as a bank.65%. Currency swaps 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. . but rather. Commodity swaps 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 payments are calculated over the notional amount. This is where a swap comes in. it is also a very crucial uniform pattern in individuals and customers.their existing obligation for their desired obligation. The vast majority of commodity swaps involve crude oil. The most common type of swap is a “plain Vanilla” interest rate swap. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. the bank takes a spread from the swap payments. Normally the parties do not swap payments directly. For example. the actual rate received by A and B is slightly lower due to a bank taking a spread. because it is reset at the beginning of each interest calculation period to the then current reference rate. with the cash flows in one direction being in a different currency than those in the opposite direction. Just like interest rate swaps.

or investment programs. and party B makes periodic interest payments. perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. Note that if the total return is negative.goes into default (fails to pay). without having to hold the underlying assets. the credit event that triggers the payoff can be a company undergoing restructuring. • 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. • An option on a swap is called a swaption. because the buyer pays a premium and. in exchange. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. • A total return swap is a swap in which party A pays the total return of an asset. receives a payoff if a instrument . then party A receives this amount from party B. Other variations There are myriad different variations on the vanilla swap structure.Credit default swaps 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. The profit or loss of party B is the same for him as actually owning the underlying asset. receives a sum of money if one of the events specified in the contract occur. bankruptcy or even just having its credit rating downgraded. is a swap that allows the purchaser to fix the duration of received flows on a swap. CDS contracts have been compared with insurance. a CMS. Less commonly. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement.typically a bond or loan . . in return. The total return is the capital gain or loss. plus any interest or dividend payments. The parties have exposure to the return of the underlying stock or index. • A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement. which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures. These provide one party with the right but not the obligation at a future time to enter into a swap.

• An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.e. There are two ways to value swaps: in terms of bond prices. the swap can be viewed as having the opposite positions. Similarly. however after this time its value may become positive or negative. That is. A swap is worth zero when it is first initiated. • 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. making floating interest payments): From the point of view of the fixed-rate payer. currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Using bond prices While principal payments are not exchanged in an interest rate swap. from the point of view of the floating-rate payer. and a deferred start swap. • 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. or as a portfolio of forward contracts. Thus. receiving fixed interest payments). Thus. assuming that these are received and paid at the end of the swap does not change its value. delayed start swap. Valuation The value of a swap is the net present value (NPV) of all estimated future cash flows.• 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. the home currency value is: . a swap is equivalent to a long position in a fixed-rate bond (i.e. and a short position in a floating rate note (i. Also referred to as a forward start swap.

at the time the contract is initiated. swaps are not exchange-traded instruments. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. foreign exchange rate. Arbitrage arguments As mentioned.. 3-month LIBOR for three months deposits. the terms of a swap contract are such that. Usually. Where this is not the case. Contingent claims. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps. Bforeign 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. forward contracts and swaps A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. One-month LIBOR is the rate offered for 1month deposits. or as a long position in one bond coupled with a short position in another bond. The Swaps Market Unlike most standardized options and futures contracts. equity price or commodity price. to be arbitrage free. Firms and financial institutions dominate the swaps market.) . options 2. arbitrage would be possible. see Futures Fundamentals and Options Basics. there is always the risk of a counterparty defaulting on the swap.e.Vswap = Bdomestic − S0Bforeign. (For background reading. where Bdomestic is the domestic cash flows of the swap. one may view a swap as either a portfolio of forward contracts. i. Because swaps occur on the OTC market. Derivatives contracts can be divided into two general families: 1. which include exchange-traded futures. initially. Conceptually. Just like the prime rate of interest quoted in the domestic market. Forward claims. etc. with few (if any) individuals ever participating. the NPV of these future cash flows is equal to zero. at least one of these series of cash flows is determined by a random or uncertain variable. such as an interest rate. Instead. LIBOR is a reference rate of interest in the international market.

and the time between are called settlement periods.200. In 1987. Because swaps are customized contracts. this figure exceeded $250 trillion. However. despite their relative youth. public equities market.S. 2006. see How do companies benefit from interest rate and currency swaps?) For example. At the end of 2007. swaps have exploded in popularity. the two cash flows are paid in the same currency. Party A agrees to pay Party B a predetermined. interest payments may be made annually. or London Interbank Offer Rate. on December 31. LIBOR. On . Company A will pay Company B $20.000. Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. By mid-2006. In this swap. The specified payment dates are called settlement dates.6 billion. quarterly. For simplicity. Concurrently. • Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. fixed rate of interest on a notional principal on specific dates for a specified period of time. Company A and Company B enter into a five-year swap with the following terms: • Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.000 * 6% = $1. beginning in 2007 and concluding in 2011. is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. That's more than 15 times the size of the U.000. according to the Bank for International Settlements.The first interest rate swap occurred between IBM and the World Bank in 1981. monthly. or at any other interval determined by the parties. Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. (For related reading. let's assume the two parties exchange payments annually on December 31. In a plain vanilla swap. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate.

one-year LIBOR was 5. which occur annually (in this example). First. a European firm.. Figure 1 shows the cash flows between the parties.December 31. Unlike an interest rate swap.000. Here. firm. the floating rate is usually determined at the beginning of the settlement period. So. the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. therefore. given the exchange rate at the time the swap is initiated. and Company D. which is why it is referred to as a "notional" amount. 2006. a U. and Company D pays ¬40 million. Company B will pay Company A $20.) Figure 1: Cash flows for a plain vanilla interest rate swap Plain Vanilla Foreign Currency Swap The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency.25 per euro (i.000.000. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap). (To learn more. the firms will exchange principals.S.e. the dollar is worth $0. enter into a five-year currency swap for $50 million.80 euro).33% + 1%) = $1. Let's assume the exchange rate at the time is $1. and Company A pays nothing. In a plain vanilla interest rate swap. Company B pays $66. For example. The two specified principal amounts are set so as to be approximately equal to one another. Company C.33%. read Corporate Use Of Derivatives For Hedging. swap contracts allow for payments to be netted against each other to avoid unnecessary payments.000 * (5.266. Company C pays $50 million. Normally. At no point does the principal change hands. .

In practice. will pay interest in dollars. each year. Then. Step 1.000 . beginning one year from the exchange of principal. let's say the agreed-upon dollar-denominated interest rate is 8.000.125.Figure 2: Cash flows for a plain vanilla currency swap.125. at the end of the swap (usually also the date of the final interest payment).125. the parties reexchange the original principal amounts. Company D will pay Company C $50. at intervals specified in the swap agreement.000 ($4. As with interest rate swaps. If. These principal payments are unaffected by exchange rates at the time. at the one-year mark.000.000 * 8.000 to Company D.960.000 * 3. Because Company C has borrowed euros. Step 2 Finally. let's say they make these payments annually. Thus.000. Figure 3: Cash flows for a plain vanilla currency swap. Company D.25% = $4.50% = ¬1. Company C pays ¬40. To keep things simple.5%. Likewise. . and the euro-denominated interest rate is 3.165. it must pay interest in euros based on a euro interest rate.960.25%. and Company D's payment would be $4. then Company C's payment equals $1. based on a dollar interest rate. the exchange rate is $1.000.400. For this example.000) to Company C. Company D would pay the net difference of $2.$1. which borrowed dollars.000.40 per euro. the parties will actually net the payments against each other at the thenprevailing exchange rate. the parties will exchange interest payments on their respective principal amounts.

. which pays a floating rate of interest on deposits (i. By then using a currency swap. this comparative advantage may not be for the type of financing desired.e. the company may acquire the financing for which it has a comparative advantage. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets. In this case. It will likely receive more favorable financing terms in the US. the firm ends with the euros it needs to fund its expansion.Figure 4: Cash flows for a plain vanilla currency swap. consider a well-known U. which would match up well with its floating-rate liabilities. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. then use a swap to convert it to the desired type of financing.S. Step 3 Who would use a swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. For example. Exiting a Swap Agreement Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination . firm that wants to expand its operations into Europe. assets). For example. where it is less well known. This mismatch between assets and liabilities can cause tremendous difficulties. liabilities) and earns a fixed rate of interest on loans (i. Some companies have a comparative advantage in acquiring certain types of financing. consider a bank.. However.e.

date. This would reduce some of the market risks associated with Strategy. a swap has a calculable market value. Use a Swaption A swaption is an option on a swap. 1. Purchasing a swaption would allow a party to set up. this is not an automatic feature. . 4. can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. one party may sell the contract to a third party. There are four basic ways to do this. but this financial tool. this requires the permission of the counterparty. Enter an Offsetting Swap For example. However. a potentially offsetting swap at the time they execute the original swap. this time receiving a fixed rate and paying a floating rate. but not enter into. or the party who wants out must secure the counterparty's consent. if used properly. Buy Out the Counterparty Just like an option or futures contract. This is similar to an investor selling an exchange-traded futures or option contract before expiration. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. so one party may terminate the contract by paying the other this market value. As with Strategy 1. Conclusion Swaps can be a very confusing topic at first. Company A from the interest rate swap example above could enter into a second swap. 2. so either it must be specified in the swaps contract in advance. Sell the Swap to Someone Else Because swaps have calculable value. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for. 3.