Definition, Examples and Types of Swaps

A swap is an agreement between two counterparties to exchange two streams of cash flows the parties the cash flow streams Purpose of swap is to change the character of an asset or liability without liquidation Issuer of swap can contract to pay a floating rate and receive a fixed rate, or vice versa. Swap contracting as we know it today is a fairly recent phenomenon. Swap market is originated from swap agreement negotiated in Great Britain in the 1970s to circumvent foreign exchange controls adopted by the British government. The first swaps were variations on currency swaps. The British government had a policy of taxing foreign exchange transactions that involved the British pound. This made it more difficult for capital to leave the country, thereby increasing domestic investment.

After that in 1981 a major swap agreement by Salomon Brothers on behalf of the World Bank and IBM and involved an exchange of cash flows denominated in Swiss francs and deutschemarks added luster to swap market.

Why are swaps so popular? What is their economic rationale?

Swaps are contractual agreements to exchange or swap a series of cash flows. This ash follows are most commonly the interest payments associated with debt service.

• If the agreement is so for one party to swap its fixed interest rate payments for the floating interest rate payments of another, it is termed as interest rate swap.
• If the agreement is to swap currencies of debt service obligation, it is termed a currency swap.
• A single swap may combine elements of both interest rate and currency swap.

Economic rationale of swap

When favorable stocks are less likely, the exposed firm chooses to issue long-term debt and uses a floating for fixed interest rate swap to take advantage of declining interest rates. These results provide an economic rationale for the widespread use of interest rate swaps by nonfinancial firms.

How would you define currency swap?

A currency swap should be distinguished from a central bank liquidity swap. A currency swap is a foreign-exchange agreement between two institutes to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

Mechanics of currency swap

The swap agreement is a contract in which one party borrows one currency from, and simultaneously lends another to, the second party. Each party uses the repayment obligation to its counterparty as collateral and the amount of repayment is fixed at the forward rate as of the start of the contract.

Role of credit ratings in SWAP

Approaching a credit rating agency is a good option for small and medium enterprises given the problem they face in seeking finance. Rating agencies assess a firm’s financial viability and capability to honor business obligations, provide an insight into sales, operational and financial composition, thereby assessing the risk element and highlights the overall health of enterprise, they also benchmark their operation within the industry as well and also plays a vital role in two counterparties of SWAP contracts.

Analyze a swap between two companies

Interest rate swaps can hedge companies against interest rate exposure. If a company makes floating interest rate payments on its liability, it can enter into a swap agreement with another company or financial institution to hedge against the risk of interest rate fluctuations. In this scenario, the company should create a swap according to which it will make fixed interest rate payments to its counterparty, while it will receive the floating interest rate payments in exchange.

It can help companies to leverage their comparative advantage in obtaining a liability. By using swaps, companies can leverage their comparative advantage in short-term or long-term borrowing and save money on interest payments. Imagine companies A and B. Company A is an AAA-rated company and it can obtain a long-term loan with a 5% interest and a short-term loan with LIBOR+0.5% interest. Company B is a BBB-rate company and it can loan long-term with an 8% interest and loan short-term with LIBOR+1%

Obviously, Company A enjoys an absolute advantage in obtaining loans over Company B because in both cases, it can obtain loan money and pay lower interest rates. However, after the calculation of the quality spreads, we can say which companies demonstrate a comparative advantage; thus, Company A should borrow long-term, while Company B should borrow short-term.

Therefore, if Company A needs a short-term loan and Company B needs a long-term loan, they can obtain loans in which they enjoy a comparative advantage and create a swap between each other. The design of the swap may look like:

Gain from SWAP between parties

Instead of paying LIBOR+1% for the short-term loan, Company A will pay LIBOR-1%, while Company B will pay an interest rate of 7% on its long-term loan, instead of 8%. Where do the gains from SWAPs arise from? Find three reasons? A currency SWAP allows the two counterparties to SWAP interest rate on borrowing in different currencies. However, gains from SWAP arise from following reasons

Flexibility

Unlike interest rate SWAP which allows companies to focus on their comparative advantage in borrowing in the single currency in the short end of the maturity spectrum, currency SWAP gives companies the extra flexibility to exploit their comparative advantage in their respective in their respective borrowing markets. They also provide a chance to exploit advantage across a network of currencies and maturity. The success of the currency swap market and the success of the Eurobond market are explicitly linked.

Exposure

Currency swaps generate a larger credit exposure than interest rate swaps because of the exchange and re-exchange of notional principal amounts. Companies have to come up with the funds to deliver the notional at the end of the contract and are obliged to exchange one currency’s notional against the other at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain.

This potential exposure is magnified as volatility increases with time. The longer the contract, the more room for the currency to move to one side or the other of the agreed upon contracted rate of principal exchange. This explains why currency swaps tie up greater credit lines than regular interest rate swaps.

Pricing

Currency swaps are priced or valued in the same way as interest rate swaps using a discounted cash flows analysis having obtained the zero coupon version of the SWAP curves. Generally, a currency swap transacts at inception with no net value. Over the life of the instrument, the currency swap can go “in-the-money,” “out-of-the-money” or it can stay “at-the-money.”

Why investors use fixed and floating rates in setting up currency SWAP?

Investors use fixed and floating rate swaps to convert financial exposure, to obtained comparative advantage, to speculate on interest rates on currencies. Let’s suppose a risk seeker investor expect the interest rate to rise and wants to lock in the fixed rate available for him/her. So he chooses a swap contract that provides him fixed interest rate. A risk-averse investor expects interest rates to decline and wants floating rate borrowing. So he chooses a swap that provides him floating interest rate.

What are the differences and similarities between FX and interest rate SWAP?

Interest rate swap The most common type of interest rate swap is one in which Party A agrees to make payments to Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on a floating interest rate. And Currency swaps are similar to an interest rate swap, except that in a currency swap, there is an exchange of principal, while in an interest rate swap, the principal does not change hands. Instead, on the trade date, the counterparties exchange notional amounts in the two currencies it is a contract or agreement between two parties wherein one party exchanges the principal and interest in one currency with principal and interest in another currency held by another party. They are also done to hedge the risk of changing interest rates and the risk of fluctuation in foreign exchange rates. The basic interest rate swap is a fixed-for-floating rate swap in which one counterparty exchanges the interest payments of a fixed-rate debt obligation for the floating-interest payments of the other counterparty. Both debt obligations are denominated in the same currency. In a currency swap, one counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty which are denominated in another currency.

A swap bank is a generic term to describe a financial institution that facilitates the swap between counterparties. The swap bank serves as either a broker or a dealer. When serving as a broker, the swap bank matches counterparties but does not assume any risk of the swap. When serving as a dealer, the swap bank stands willing to accept either side of a currency swap. In an example of a basic interest rate swap, it was noted that a necessary condition for a swap to be feasible was the existence of a quality spread differential between the default-risk premiums on the fixed-rate and floating-rate interest rates of the two counterparties. Additionally, it was noted that there was not an exchange of principal sums between the counterparties to an interest rate swap because both debt issues were denominated in the same currency. Interest rate exchanges were based on a notional principal. After inception, the value of an interest rate swap to a counterparty should be the difference in the present values of the payment streams the counterparty will receive and pay on the notional principal.

In a detailed example of a basic currency swap, it was shown that the debt service obligations of the counterparties in a currency swap are effectively equivalent to one another in cost. Nominal differences can be explained by the set of international parity relationships. After inception, the value of a currency swap to a counterparty should be the difference in the present values of the payment stream the counterparty will receive in one currency and pay in the other currency, converted to one or the other currency denomination.

In addition to the basic fixed-for-floating interest rate swap and fixed-for-fixed currency swap, many other variants exist. One variant is the amortizing swap, which incorporates an amortization of the national principles. Another variant is a zero-coupon-for-floating rate swap in which the floating-rate payer makes the standard periodic floating-rate payments over the life of the swap, but the fixed-rate payer makes a single payment at the end of the swap. Another is the floating-for-floating rate swap. In this type of swap, each side is tied to a different floating-rate index or a different frequency of the same index. Reasons for the development and growth of the swap market should be critically examined. We argue that one must rely on an argument of market completeness for the existence and growth of interest rate swaps. That is, the interest rate swap market assists in tailoring financing to the type desired by a particular borrower when all types of debt instruments are not regularly available to all borrowers

How many types of swaps?

The following types of the swap are:

1. Basis Rate. A basis swap is an interest rate swap which involves the exchange of two floating rate financial instruments. A basis swap functions as a floating-floating interest rate swap under which the floating rate payments are referenced to different bases
2. Bond Swap. In simple terms, a bond swap is when an investor chooses to sell one bond and subsequently purchase another bond with the proceeds from the sale in order to take advantage of the current market environment. Investors may choose to swap a bond for a wide variety of reasons
3. Commodity Swap. A commodity swap is a type of swap agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period. A Commodity swap is similar to a Fixed-Floating Interest rate swap.
4. Credit Default Swap. A financial contract whereby a buyer of corporate or sovereign debt in the form of bonds attempts to eliminate possible loss arising from default by the issuer of the bonds. This is achieved by the issuer of the bonds insuring the buyer’s potential losses as part of the agreement.
5. Volatility Swap. A volatility swap is a forward contract on future realized price volatility. Similarly, a variance swap is a forward contract on future realized price variance, variance being the square of volatility. In both cases, at the inception of the trade, the strike is usually chosen such that the fair value of the swap is zero.
6. Forex Swap. A forex swap is the interest rate differential between the two currencies of the pair you are trading, and it is calculated according to whether your position is long or short. The FxPro Swap Calculator can be used to determine what your swap fee will be for holding a trade open overnight.
7. Interest rate swap. Interest rate swap is a contract or agreement between two parties wherein one set of fixed future cash flows of interest payments is exchanged for another set of floating future cash flows of interest payments based on usually a same principal amount. The payment is not of the principal amount but of the interest amount that is exchanged in order to hedge the risk of fluctuating interest rates or can be described as swapping of fluctuating interest rates and floating interest rates.
8. Currency swap. Currency swaps is a contract or agreement between two parties wherein one party exchanges the principal and interest in one currency with principal and interest in another currency held by another party. They are also done to hedge the risk of changing interest rates and the risk of fluctuation in foreign exchange rates.
9. Cross currency swap. A cross-currency swap is an over the counter derivative in a form of an agreement between two parties to exchange interest payments and principals on loans denominated in two different currencies.