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A swap is a derivative instrument where the two contracting parties agree to exchange a set number of cash flows from the financial instruments owned by both the parties for a certain period of time. Swaps are over the counter instruments and are generally facilitated by various financial institutions, who may or may not be a party to the swap. As the name suggest, it is literally a swap of cash flows and the attached risks. The two sides of the series of cash flows which are exchanged are also referred to as the legs of the swap.
Uses of Swaps
Swaps are used by various businesses to hedge their risks. If a business is having fixed rate cash inflows while floating rate cash outflows, it can enter into a swap to exchange its fixed rate inflows for floating rate inflows, so that both the inflows and outflows become floating rate and the risk is hedged. Similarly, someone importing raw material in one currency while exporting the finished products in a different currency can enter into swaps to exchange the exporting currency inflows for the importing currency inflows. This way, he will be hedged against any currency fluctuations. For financial institutions, swaps is a big business as they get their commission for being the intermediary between two contracting parties. They have also been able to innovate and come up with a wide variety of swaps to cater to emerging business needs.
Types of Swaps
Some commonly used types of swaps are as below:
Interest Rate Swap
An interest rate swap is the simplest form of swap. Here, one party agrees to pay a floating interest rate payment while the other party agrees to pay a fixed interest rate payment. The floating interest rate is linked to a benchmark rate, such as LIBOR. The principal on which the interest payments are calculated is called the notional principal. One point to note is that it’s only the interest payments which are exchanged and not the notional principal. For example, company A has a loan of $10 mn which has a floating rate of LIBOR+2% while company B also has a loan of $10 mn but with a fixed rate of 6%. Company A wants to pay a fixed rate of interest while the company B wants to pay a floating rate of interest. A bank, knowing the situation of both the companies, will come in between and design a swap for both the parties. In such a swap, company A would pay 5.5% fixed to company B while company B will pay LIBOR+1.5% to company A. Bank will receive a commission of, say, 0.25% of the notional.
It is another popular form of a swap. Here, one party agrees to pay the principal and interest on one currency in return for the principal and interest on another currency. Please note that as opposed to the interest rate swap, the principal is also exchanged in a currency swap. A currency swap is generally initiated between the companies which have loans outstanding in a currency different than their normal business currency. The companies can even be from different countries. For example, a British company A has a loan outstanding of USD 15 mn at 4% interest while an American company B has a loan outstanding of GBP 10 mn at 2.5% interest. If the current exchange rate is 1.5 USD for 1 GBP, the principal amount for both the companies match. A banker can facilitate a currency swap agreement between them where they exchange the cash flows on their respective loans.
In an equity swap, an equity investor can exchange returns on his share with a fixed or floating rate for a certain period of time. The investor can hedge the equity downside while still holding on to the voting rights of the equity, which he would have lost if he sold the equity.
In a commodity swap, one party agrees to exchange a floating commodity price for a fixed price for a certain period of time. It is essentially like hedging your cash flows with a futures contract.
A swaption is basically an option to enter into a swap agreement at a later date.
There can be many other types of exotic swaps such as volatility swaps, variance swaps, total return swaps, forward swap, amortising swap, deferred rate swap, zero coupon swap, inflation swap and correlation swap, etc.
Options, Futures and Other Derivatives by John C Hull