Swap (finance)

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is an interest rate swap. 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 return 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.

A basis swap involves exchanging floating interest rates based on different money markets. The principal is not exchanged. The swap effectively limits the interest-rate risk as a result of having differing lending and borrowing rates.[20]

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 are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.

An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms. The primary objective is to hedge against inflation and interest-rate risk.[21]

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.

An agreement whereby the payer periodically pays premiums, sometimes also or only a one-off or initial premium, to the protection seller on a notional principal for a period of time so long as a specified credit event has not occurred.[22] The credit event can refer to a single asset or a basket of assets, usually debt obligations. In the event of default, the payer receives compensation, for example the principal, possibly plus all fixed rate payments until the end of the swap agreement, or any other way that suits the protection buyer or both counterparties. The primary objective of a CDS is to transfer one party's credit exposure to another party.

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.

An agreement to exchange future cash flows between two parties where one leg is an equity-based cash flow such as the performance of a stock asset, a basket of stocks or a stock index. The other leg is typically a fixed-income cash flow such as a benchmark interest rate.

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.[4]

• 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.[22]
• 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.[22]
• A variance swap is an over-the-counter instrument that allows investors to trade future realized (or historical) volatility against current implied volatility.[23]
• A constant maturity swap (CMS) is a swap that allows the purchaser to fix the duration of received flows on a swap.
• An amortizing 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 as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.[22]
• 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.
• 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.
• 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.
• 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. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.
• A quanto swap is a cash-settled, cross-currency interest rate swap in which one counterparty pays a foreign interest rate to the other, but the notional amount is in domestic currency. The second party may be paying a fixed or floating rate. For example, a swap in which the notional amount is denominated in Canadian dollars, but where the floating rate is set as USD LIBOR, would be considered a quanto swap. Quanto swaps are known as differential or rate-differential or diff swaps.
• A range accrual swap (or range accrual note) is an agreement to pay a fixed or floating rate while receiving cash flows from a fixed or floating rate which are accrued only on those days where the second rate falls within a preagreed range. The received payments are maximized when the second rate stays entirely within the range for the duration of the swap.
• A three-zone digital swap is a generalization of the range accrual swap, the payer of a fixed rate receives a floating rate if that rate stays within a certain preagreed range, or a fixed rate if the floating rate goes above the range, or a different fixed rate if the floating rate falls below the range.

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 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.

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 is equivalent to 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):

${\displaystyle V_{\mathrm {swap} }=B_{\mathrm {fixed} }-B_{\mathrm {floating} }\,}$

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

${\displaystyle V_{\mathrm {swap} }=B_{\mathrm {floating} }-B_{\mathrm {fixed} }\,}$

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:

${\displaystyle V_{\mathrm {swap} }=B_{\mathrm {domestic} }-S_{0}B_{\mathrm {foreign} }}$, where ${\displaystyle B_{\mathrm {domestic} }}$ is the domestic cash flows of the swap, ${\displaystyle B_{\mathrm {foreign} }}$ 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. 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.