Swaps, as the word suggests, means the exchange. But, in the financial world, especially the derivatives market, a swap means the exchange of the cash flows between two parties. We can say that it is a derivative agreement between two traders or investors for the exchange of pre-decided cash flows from two financial instruments. The parties determine the cash flows with the help of a notional principal amount. We call each stream of cash flows a ‘leg.’ A swap can be of different financial instruments. In this piece, we will be discussing the different types of swaps.
Types of Swaps
Traders or investors use a variety of swaps for varying purposes. Following are the different types of swaps:
Interest Rate Swap
In this, the parties decide to switch one type of interest rate payment with another type of interest rate payment. Generally, the interest rate swap is of floating and fixed exchange rates. An important point is that the investors do not exchange the principal amount, rather only the interest rate. Interest rate swaps are of many types. These are:
Plain vanilla swap – this is the simplest interest rate swap. In this, the parties swap the fixed with a floating interest rate or vice versa. The parties decide beforehand the intervals or time when they will be exchanging the interest rate during the contract life.
Basis swap – this swap comes into play if both the legs have a floating rate. In such a case, parties would be able to swap the floating rates by using benchmark rates as the standard.
Amortizing swap – in this, a party can offer a drop in the notional amount equaling the amortization of a loan.
Step-up swap – this swap is the exact opposite of the amortizing swap. In this, the notional amount rises.
Differential swap – in this swap, one leg involves the payment of interest rate in a currency different from the initial principal amount. The other leg, however, involves the payment of interest rate in the currency of the initial principal.
In this swap, the parties agree to swap the principal and interest money in distinct currencies. These swaps are practiced basically to hedge the currency exchange rate fluctuations. We can say that it involves the exchange of interest and principal payments in one currency with the interest and principal money in another currency. Such swaps have more credit exposure in comparison to the interest rate swap.
For example, Company X is an Indian firm that wants to start a venture in the US. Similarly, there is one Y company is from the US that has a plan to set up a firm in India. The two firms enter into a currency swap agreement. This way, Company X will take a low-cost in its home market and give it to Company Y. And, Company Y will take a low-cost loan in the US and give it to Company X.
Also, when the EMI is due, each company will make the interest payment to another company, who would then pass it on to the financial institution.
One can also club the currency swap with the interest rate swap. For instance, one company can swap its USD fixed interest rate loan with a floating interest rate loan in Euro.
Unlike its name, this swap does not involve the swap of any commodity. This swap enables the parties to swap floating cash flows depending upon the spot rate of a commodity with the fixed cash flows, which are on the basis of the commodity’s pre-determined price. The majority of commodity swap agreements involve oil.
Such a swap enables investors to hedge against commodity price fluctuations. Companies that use commodities as input or raw material use such a swap to protect them from the risk of fluctuations in their price.
For example, an airline will use such a swap and decide on making a fixed payment at regular intervals, such as every three months for three years. In return, the airline will get the payment on the same dates on the basis of the oil price index. In this example, suppose the two parties agree on a fixed payment of $50 per barrel. If after three months, the index represents a price of $55 per barrel, one party will still be liable to pay $50 per barrel, but in exchange, it would get $55 per barrel.
Credit Default Swap
These swaps work like an insurance policy and offer protection against the default of a debt instrument. We also call such swaps as CDS. In this, the buyer will make a premium payment to the seller of the swap. And, if there is a default, the seller will reimburse the buyer an amount equaling the face value of that asset. Also, the buyer transfers the ownership of that asset to the seller.
Investors can use CDS for many types of debt instruments, including MBS (mortgage-backed securities), emerging market bonds, and other bonds (corporate and government). JP Morgan was the first to come up with such swaps in 1995.
CDS played a crucial role in triggering the 2008 Global Financial Crisis. Billionaire and legendary investor Warren Buffett refers to these swaps as “financial weapons of mass destruction.”
These are relatively new types of swaps. As the name suggests, the underlying security in this swap is the stock, or stocks, or a stock index. In this swap, parties swap any potential rise in the stock value, as well as dividends for a guaranteed payment with adjustment for any drop in the value of the stock.
Basically, in this swap, one party has to give up all claims on the price and dividends from the stock in exchange for a fixed payment. Unlike buying a stock, in this swap, the holder does not make any payment upfront. However, the holder does not get any voting or other rights that shareholders enjoy.
Such a swap helps investors to diversify their risk, as well as offer tax benefits. Moreover, it also helps big businesses to hedge specific assets or positions in their portfolio.
Many regard equity swap as the best swap. This is because they are over-the-counter (OTC) instruments, and thus, are customizable. So, investors can customize them as per their time horizon, risk appetite, investment objectives, and other factors.
Zero Coupon Swap
Such a swap works similar to the interest rate swap but gives more freedom to one of the parties. For instance, in a fixed-to-floating zero coupon swap, the party does not need to make the fixed payments regularly. Rather, the party can make the payment just once, and that too at the expiration rate, or when the contract ends. The other party, however, will continue to make regular floating payments.
There is also a fixed-fixed zero coupon swap. In this, one party makes just one payment at the end, while the other party keeps making regular fixed payments.
Total Return Swap
Such a swap enables a party to enjoy the benefits of security, without actually owning it. We also call such a swap TRS. This swap involves the agreement between a total return payer and a total return receiver. The payer has to make the payment of total return (any income and capital appreciation) on a security to the receiver. In exchange, the payer gets a fixed or floating payment from the receiver. The underlying security could be any, including stock, bond, commodity, or more.
As said above, in this swap, one party enjoys the benefits of security without owning it. The other party benefits as it is able to transfer all credit and market risk, and get a guaranteed payment in return.
Continue reading – Swaption.
Frequently Asked Questions (FAQs)
A swap means the exchange of cash flows between two parties. It is a derivative agreement between two traders or investors for the exchange of pre-decided cash flows from two financial instruments. The parties determine the cash flows with the help of a notional principal amount. A swap can be of different financial instruments.
Following are the different types of swaps:
1. Interest rate swap
2. Currency swap
3. Commodity swap
4. Credit default swap
5. Equity swap
6. Zero coupon swap
7. Total return swap
Interest rate swaps are of many types. These are:
1. Plain vanilla swap
2. Basis swap
3. Amortizing swap
4. Step-up swap
5. Differential swap
Unlike its name, this swap does not involve the swap of any commodity. This swap enables the parties to swap floating cash flows depending upon the spot rate of a commodity with the fixed cash flows, which are on the basis of the commodity’s pre-determined price.