Swaps and types of swaps
Swaps are derivative instruments that represent an agreement between two
parties to exchange a series of cash flows over a specific period. Swaps offer
great flexibility in designing and structuring contracts based on mutual
agreement. This flexibility generates many swap variations, with each
serving a specific purpose.
“Swaps in finance involves a contract between two or more party on a
derivative contract which involves the exchange of cash flow based on a
predetermined notional principal amount, which usually includes interest
rate swaps which is the exchange of floating rate interest with a fixed rate
of interest and the currency swaps which is the exchange of fixed currency
rate of one country with floating currency rate of another country etc.”
There are multiple reasons why parties agree to such an exchange:
• Investment objectives or repayment scenarios may have changed.
• There may be increased financial benefit in switching to newly available
or alternative cash flow streams.
• The need may arise to hedge or mitigate risk associated with a floating
rate loan repayment.
Different Types of Swaps
1. Currency Swaps
Cross-currency swaps are agreements between counterparties to exchange interest
and principal payments in different currencies. Like a forward, a cross-currency
swap consists of the exchange of principal amounts (based on today’s spot rate)
and interest payments between counter-parties. It is considered to be a foreign
exchange transaction and is not required by law to be shown on the balance sheet.
In a currency swap, these streams of cash flows consist of a stream of interest and
principal payments in one currency exchanged for a stream, of interest and
principal payments of the same maturity in another currency. Because of the
exchange and re-exchange of notional principal amounts, the currency swap
generates a larger credit exposure than the interest rate swap.
Cross-currency swaps can be used to transform the currency denomination of
assets and liabilities. They are effective tools for managing foreign currency risk.
They can create currency matches within its portfolio and minimize exposures.
Firms can use them to hedge foreign currency debts and foreign net investments.
Currency swaps give companies extra flexibility to exploit their comparative
advantage in their respective borrowing markets. Currency swaps allow companies
to exploit advantages across a matrix of currencies and maturities.
Currency swaps were originally done to get around exchange controls and hedge
the risk on currency rate movements. It also helps in reducing costs and risks
associated with currency exchange.
, 2. Credit Default Swap
A credit Default Swap is a financial instrument for swapping the risk of debt
default. Credit default swaps may be used for emerging market bonds,
mortgage-backed securities, corporate bonds, and local government bonds.
• The buyer of a credit default swap pays a premium for effectively
insuring against a debt default. He receives a lump sum payment if
the debt instrument defaults.
• The seller of a credit default swap receives monthly payments from
the buyer. If the debt instrument defaults, they have to pay the agreed
amount to the buyer of the credit default swap.
The first credit default swap was introduced in 1995 by JP Morgan. By
2007, their total value has increased to an estimated $45 trillion to $62
trillion. Although since only 0.2% of the Investment Company’s default, the
cash flow is much lower than this actual amount. Therefore, this shows that
credit default swaps are being used for speculation and not insuring against
actual bonds.
3. Commodity Swap
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 oil. A swap where exchanged cash
flows depend on an underlying commodity's price. This swap is usually
used to hedge against the price of a commodity. Commodities are physical
assets such as precious metals, base metals, energy stores (such as natural
gas or crude oil), and food (including wheat, pork bellies, cattle, etc.).
In this swap, the user of a commodity would secure a maximum price and
agree to pay a financial institution this fixed price. Then in return, the user
would get payments based on the market price for the commodity involved.
4. Equity Swap
The outstanding performance of equity markets in the 1980s and the 1990s have
brought in some technological innovations that have made widespread
participation in the equity market more feasible and more marketable and the
demographic imperative of baby-boomer saving has generated significant interest
in equity derivatives. In addition to the listed equity options on individual stocks
and individual indices, a burgeoning over-the-counter (OTC) market has evolved in
the distribution and utilization of equity swaps.
An equity swap is a special type of total return swap, where the underlying
asset is a stock, a basket of stocks, or a stock index. 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. An equity swap permits
an equity holder a guaranteed return but demands the holder give up all
rights to appreciation and dividend income. Compared to owning the stock,
in this case, you do not have to pay anything upfront, but you do not have
any voting or other rights that stockholders do have.
Equity swaps make the index trading strategy even easier. Besides
Swaps are derivative instruments that represent an agreement between two
parties to exchange a series of cash flows over a specific period. Swaps offer
great flexibility in designing and structuring contracts based on mutual
agreement. This flexibility generates many swap variations, with each
serving a specific purpose.
“Swaps in finance involves a contract between two or more party on a
derivative contract which involves the exchange of cash flow based on a
predetermined notional principal amount, which usually includes interest
rate swaps which is the exchange of floating rate interest with a fixed rate
of interest and the currency swaps which is the exchange of fixed currency
rate of one country with floating currency rate of another country etc.”
There are multiple reasons why parties agree to such an exchange:
• Investment objectives or repayment scenarios may have changed.
• There may be increased financial benefit in switching to newly available
or alternative cash flow streams.
• The need may arise to hedge or mitigate risk associated with a floating
rate loan repayment.
Different Types of Swaps
1. Currency Swaps
Cross-currency swaps are agreements between counterparties to exchange interest
and principal payments in different currencies. Like a forward, a cross-currency
swap consists of the exchange of principal amounts (based on today’s spot rate)
and interest payments between counter-parties. It is considered to be a foreign
exchange transaction and is not required by law to be shown on the balance sheet.
In a currency swap, these streams of cash flows consist of a stream of interest and
principal payments in one currency exchanged for a stream, of interest and
principal payments of the same maturity in another currency. Because of the
exchange and re-exchange of notional principal amounts, the currency swap
generates a larger credit exposure than the interest rate swap.
Cross-currency swaps can be used to transform the currency denomination of
assets and liabilities. They are effective tools for managing foreign currency risk.
They can create currency matches within its portfolio and minimize exposures.
Firms can use them to hedge foreign currency debts and foreign net investments.
Currency swaps give companies extra flexibility to exploit their comparative
advantage in their respective borrowing markets. Currency swaps allow companies
to exploit advantages across a matrix of currencies and maturities.
Currency swaps were originally done to get around exchange controls and hedge
the risk on currency rate movements. It also helps in reducing costs and risks
associated with currency exchange.
, 2. Credit Default Swap
A credit Default Swap is a financial instrument for swapping the risk of debt
default. Credit default swaps may be used for emerging market bonds,
mortgage-backed securities, corporate bonds, and local government bonds.
• The buyer of a credit default swap pays a premium for effectively
insuring against a debt default. He receives a lump sum payment if
the debt instrument defaults.
• The seller of a credit default swap receives monthly payments from
the buyer. If the debt instrument defaults, they have to pay the agreed
amount to the buyer of the credit default swap.
The first credit default swap was introduced in 1995 by JP Morgan. By
2007, their total value has increased to an estimated $45 trillion to $62
trillion. Although since only 0.2% of the Investment Company’s default, the
cash flow is much lower than this actual amount. Therefore, this shows that
credit default swaps are being used for speculation and not insuring against
actual bonds.
3. Commodity Swap
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 oil. A swap where exchanged cash
flows depend on an underlying commodity's price. This swap is usually
used to hedge against the price of a commodity. Commodities are physical
assets such as precious metals, base metals, energy stores (such as natural
gas or crude oil), and food (including wheat, pork bellies, cattle, etc.).
In this swap, the user of a commodity would secure a maximum price and
agree to pay a financial institution this fixed price. Then in return, the user
would get payments based on the market price for the commodity involved.
4. Equity Swap
The outstanding performance of equity markets in the 1980s and the 1990s have
brought in some technological innovations that have made widespread
participation in the equity market more feasible and more marketable and the
demographic imperative of baby-boomer saving has generated significant interest
in equity derivatives. In addition to the listed equity options on individual stocks
and individual indices, a burgeoning over-the-counter (OTC) market has evolved in
the distribution and utilization of equity swaps.
An equity swap is a special type of total return swap, where the underlying
asset is a stock, a basket of stocks, or a stock index. 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. An equity swap permits
an equity holder a guaranteed return but demands the holder give up all
rights to appreciation and dividend income. Compared to owning the stock,
in this case, you do not have to pay anything upfront, but you do not have
any voting or other rights that stockholders do have.
Equity swaps make the index trading strategy even easier. Besides
