A Swap is a type of derivative, which is a product whose value is derived from the value of one or more basic variables called bases. Swaps essentially allow parties to exchange their uncertain stream of cash flows for a more certain one. They are infinitely flexible instruments.
Nature and Features
Unlike standardized, exchange-traded futures contracts, swaps are typically customized contracts that are traded in the over-the-counter (OTC) market between private parties. They are private agreements between two parties to exchange sequences of cash flows for a set period of time. These cash flows are exchanged at specified intervals, which are referred to as payment or settlement dates. At the initiation of the contract, at least one of these cash flow series is usually determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price, or commodity price.
Conceptually, a swap can be viewed as either a portfolio of forward contracts or as a long position in one bond coupled with a short position in another bond. The vast majority of swaps are traded OTC through swap dealers, which are typically large financial institutions or brokerage houses. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. This contrasts with exchange-traded derivatives like futures, where the clearing corporation acts as the counterparty, reducing this risk [as discussed in previous conversations].
The amount of cash flow exchange in swaps is typically huge, and the process is complex, necessitating intermediaries. These facilitators can be brokers, who initiate the counterparties to finalize the swap deal, or swap dealers, who are themselves counterparties that bear risk and provide portfolio management services.
A key feature of most swaps is the concept of a notional principal amount. This is the face value of a security or a specified amount borrowed or lent. For calculating the payment streams, this notional principal is used. However, the notional principal amount itself is never actually exchanged between the parties, except in the case of currency swaps. Interim payments in swaps are usually netted, meaning only the difference between the amounts due is paid by one party to the other.
The main users of swaps are large multinational banks or corporations. Swaps create credit exposures and are individually designed to meet the risk-management objectives of the participants.
Types of Financial Swaps
The sources highlight several major types of financial swaps:
- Interest Rate Swaps (IRS): Also known as a rate swap, this is an agreement between two parties to exchange a sequence of interest payments in the same currency. The exchange occurs without swapping the underlying debt principal. A prevalent practice is to exchange a fixed rate interest for a floating rate one. Types of interest rate swaps include:
- Plain Vanilla Swap (Generic Swap or Coupon Swap): This is the simplest example of an interest rate swap, involving the exchange of fixed rate interest for floating rate interest payments in the same currency over a period of time on a notional principal. The floating rate basis can be a benchmark like SOFR, ESTER, SONIA, MIBOR, or Prime Lending Rate. Formulas are used to calculate the fixed and floating rate payments based on the notional principal, applicable rates, and number of days.
- Basis Rate Swap (Non-Generic Swap): Similar to a plain vanilla swap, but the payments are based on the difference between two different variable rates, measured against different benchmarks (e.g., one party pays based on 1-month SOFR, the other based on 3-month SOFR). Both “legs” of the swap are floating.
- Overnight Index Swap (OIS): An example mentions a plain vanilla swap entered into through an OIS.
- Currency Swaps: These involve an exchange of liabilities between currencies. Currency swaps, sometimes called cross-currency swaps, are agreements where principal and interest payments in one currency are exchanged for such payments in another currency. The exchange includes both interest and principal payments of the same maturity. By swapping cash flow obligations, counterparties can replace cash flows in one currency with cash flows in a more desired currency. For example, a company with Yen debt at a fixed rate can use a currency swap to transform it into a fully hedged U.S. dollar liability by exchanging cash flows with a counterparty. Unlike other swaps, currency swaps involve the exchange and re-exchange of notional principal amounts, which generates a larger credit exposure than interest rate swaps. Currency swaps can consist of three stages.
- Commodity Swaps: These involve the exchange of cash flows based on the price of commodities.
- Equity Swaps: A special type of total return swap where the underlying asset is a stock, a basket of stocks, or a stock index. In an equity swap, there is an exchange of the potential appreciation of equity’s value and dividends for a guaranteed return plus any decrease in the value of the equity.
- Credit Default Swaps (CDS): A financial instrument for swapping the risk of debt default. It is a credit derivative contract where the buyer makes periodic payments (a premium) to the seller in return for a payoff if the underlying financial instrument defaults or experiences a similar credit event. The underlying can include emerging market bonds, mortgage-backed securities, corporate bonds, or local government bonds. The buyer effectively insures against default, receiving a lump sum if it occurs, while the seller receives the periodic payments but must pay the agreed amount if default happens. CDS can be used for hedging.
Benefits of Using Swaps
The systematic use of swaps can provide several advantages:
- Borrowing at Lower Cost: Swaps facilitate borrowings at a lower cost, working on the principle of comparative cost theory. One borrower exchanges the comparative advantage they possess with the comparative advantage of another borrower, allowing both parties to potentially get funds at cheaper rates.
- Access to New Financial Markets: Swaps are used to gain access to new financial markets by exploring the comparative advantage possessed by the other party in that market. This allows funds to be obtained from the best possible source at cheaper rates by fully exploiting comparative advantages.
- Hedging of Risk: Swaps can be used to hedge risk. For example, a company with a fixed rate bond obligation that anticipates a decline in interest rates can enter into a swap agreement to exchange its fixed rate obligation for a floating rate obligation, thus benefiting from the potential future fall in rates. Swaps are listed as one of the four basic financial derivatives, used as instruments for risk management.
Related Concepts: Swaptions
A Swaption is an option on an interest rate swap. It combines features of both options and swaps. A swaption gives the holder the right, but not the obligation, to enter into an interest rate swap at a specific future date (the exercise date), at a particular fixed rate, and for a specified term. The swaption agreement defines whether the buyer will be a fixed rate receiver or a fixed rate payer if the option is exercised.
- A fixed rate payer swaption (also called a Call Swaption) gives the owner the right to enter a swap where they pay the fixed leg and receive the floating leg.
- A puttable swap (related to a put swaption) provides the party making floating rate payments with a right to terminate the swap, making the writer the floating rate receiver and fixed rate payer. Swaptions can also provide protection on callable/puttable bond issues.
Valuation of Interest Rate Swaps
For a plain vanilla interest rate swap, valuation can be approached by considering the fixed leg as a fixed coupon bond and the floating leg as a floating rate note. At maturity, the parties are considered to give each other equal amounts of money. The pricing of the swap is the value of the fixed coupon bond minus the value of the floating rate note (V = FB – FF). As market rates change after the initial pricing, the values of both the fixed and floating legs will change, potentially making it an “off-market swap” where the value is not zero.
In summary, swaps are highly flexible, customized OTC derivative contracts used predominantly by large institutions to exchange cash flows, manage risk (such as interest rate and currency risk), gain access to funding at lower costs, and access new markets. While similar to forwards in some ways (e.g., private agreement), their structure involving multiple cash flow exchanges over time and the use of notional principal (except in currency swaps) distinguishes them. Related instruments like swaptions provide options on entering into future swap agreements.