What is a Swap?
A swap is an agreement or a derivative contract between two parties for a financial exchange so that they can exchange cash flows or liabilities. Through a swap, one party promises to make a series of payments in exchange for receiving another set of payments from the second party. Swaps usually include cash flows based on notional principal amounts like bonds or loans but the instruments can vary.
Understanding Swap
Swaps can be considered as a relatively new type of derivative as they were introduced in the late 1980s and have quickly become one of the most commonly and frequently used traded financial contracts.
The most common type of swap is an interest rate swap (it will be explained in detail when we discuss the types of swaps). Swaps are over the counter (OTC) contracts that are majorly between businesses or financial institutions and are customised to satisfy the demands of both parties. Unlike options and futures, swaps are not traded on exchanges and are usually not opted for by individuals as they involve a high risk of counterparty default.
You can find examples of swap quite easily as several large-scale companies finance their business by issuing debt bonds (they pay a fixed interest rate to investors on these bonds). They often contract a swap to convert these fixed payments into variable rate payments (these are linked to market rates), thereby optimising the company’s debt structure. Corporate finance professionals and CFOs may use swap contracts to reduce the uncertainty of operations and hedge risk respectively.
A swap is defined based on the following:
-The start and end date of the swap -The nominal amount (amount on which the payment of the parties are calculated) -Frequency of payment -The interest rate or margin of the parties -Index of reference (for the variable part eg, Euribor is the most common reference rate in Europe)
There are some financial institutions (known as swap banks) that facilitate these transactions by the matching counterparties.
Types of swaps
While there are countless types of swaps out there, we have listed the most common ones below.
Interest Rate Swaps
Interest rate swaps involve parties exchanging cash flows so that they can fedge against an interest rate risk or speculate. These cash flows are based on a notional principal amount that is agreed upon by both the parties (this amount is not exchanged). These are the most commonly used swaps and are also known as plain vanilla interest swaps. In this, party A pays Party B a predetermined (and fixed) rate of interest for a specific period of time on specific dates. Following this, party B agrees to pay party A on a floating interest rate with the same notional principal for the same amount of time on the same dates. The currency used in both the cash flows is the same and the dates (called settlement dates) are decided beforehand by both the parties. The payments are usually made monthly, quarterly or annually but the time interval can be set in any manner by the parties involved.
Commodity Swaps
Commodity swaps involve the exchange of a floating commodity price and consists of a floating leg component and a fixed leg component. The former is linked to the market price of the underlying commodity (like oil, fuel, precious metals, livestock, grains, etc) while the latter is specified in the contract as the producer of the commodity decides to pay a floating rate (it is determined by the spot market price of the underlying commodity). The most commonly used commodity for these swaps is crude oil and generally involve large institutions due to the nature and size of the contracts. A commodity swap is usually used to hedge against the price change in the market for crucial and valuable commodities like livestock, oil, etc. These are customised deals that are made outside of formal exchanges, without the oversight of an exchange regulator.
Currency Swaps
In a currency swap, both the parties exchange interest as well as principal payments on the debt (it is denominated in different currencies). This is not based on a notional amount but is exchanged along with the interest obligations. These contracts might involve different countries. For instance, the U.S. Federal Reserve and the European central banks were engaged in an aggressive swap strategy to stabilize the euro, as its value was falling because of the Greek debt crisis. These were initially used to get around exchange controls and government limitations on the purchase or sale of currencies and are often used by companies who do business abroad as they can help them get favourable loan rates in the local currency. These are considered to be a part of foreign exchange transactions and hence are not required by law to be included in the balance sheet of the company.
Debt-Equity Swaps
Debt or equity swaps act as a refinancing deal that involves the exchange of debt for equity. In this swap, the debt holder gets an equity position for the cancellation of the debt. It paves a way for struggling companies to relocate their capital structure. Since such companies can’t pay off their debts, they opt to get involved in debt-equity swaps to delay the payment. While some debt holders have to agree to this swap due to bankruptcy, others do have a choice in the matter as some companies engage in debt-equity swaps to reap the benefits of the favourable market conditions. The covenants in the bond indenture may oppose and prevent the swap without consent. For instance, businesses often offer attractive trade ratios like 1:2 wherein the bondholder receives stocks worth twice the value of his bonds, which makes the trade more enticing.
Total Return Swaps
In total return swaps, the overall returns from an asset are traded for a fixed (or variable) interest rate. This exposes the party that is paying the fixed rate to the underlying asset which is usually a stock, bond or index. Hence the second party can reap benefits from this asset without actually owning it. The parties involved in this swap are called total return payer and total return receiver.
Credit Default Swap (CDS)
In CDS, both the parties get into an agreement in which the one pays the lost principal and interest of a loan to the CDS buyer in case a borrower defaults on the loan. CDS swap was one of the major contributing factors in the 2008 financial crisis along with poor risk management and excessive leverage as the investors offset their credit risk with that of another investor. The majority of the CDS contracts are maintained via an ongoing premium payment (which is quite similar to the regular premiums due on an insurance policy) and usually involve mortgage-backed securities or municipal and corporate bonds.
