What Are Swaps?

A derivatives contract can be broadly divided into the following general families. First, there are contingent claims, otherwise known as options. Secondly, there are forward claims, which also include exchange-traded futures, swaps, or forward contracts. Of these, swap derivatives are an agreement that occurs between two parties with the goal to exchange a sequence of cash flows over a certain duration.

Typically, at the time at which one initiates the contract, at least one of these cash flows will be determined through an uncertain or random variable, like foreign exchange rate, interest rate, equity price, or a commodity price. On a conceptual basis, one might view the swap as either a long position in a single bond that is coupled with a short position in a separate bond. Alternatively, they may view them as a portfolio of forward contracts.

What Is Swap Trading?

Hence, in response to the question of ‘what is swap derivative’: it is a contract wherein two parties decide to exchange liabilities or cash flows from separate financial instruments. Oftentimes, swap trading will be based on loans or bonds, otherwise known as a notional principal amount, although the instrument that will be used for swap derivatives can be anything. Oftentimes, the principal amount will not change hands. One cash flow is variable and based on a floating currency exchange rate, benchmark interest rate, or index rate while the other may be fixed.

When it comes to the function of swap trading, the motivations for going ahead with a swap fall under two categories: competitive advantage and commercial needs. Although there are many types, the most common kind of swap is known as an interest rate swap. A swap will not occur on any of the public stock exchanges and it is not common for retail investors to engage in a swap.

Rather, swaps are contracts that are over-the-counter primarily between financial institutions or businesses that are customized to the needs of both parties. Financial institutions and firms dominate the swap derivatives market, with almost no individuals ever participating. As a result of swaps occurring on the over-the-counter market, there is typically the risk that a counter-party will default on it.

Types Of Swaps

The instruments that are exchanged in a swap need not be interest payments. In fact, there exist countless variations of exotic swap agreements. The relatively common agreements include currency, swaps, debt swaps, commodity swaps, and total return swaps.

  • Interest Rate Swaps: The simplest and most common type of swap is known as a plain vanilla interest swap. In such a swap, Party A agrees to pay Party B a fixed and predetermined rate of interest on a notional principal for a specified period of time on specific dates. Consequently, Party B agrees to make any payments to Party A on a floating interest rate with the same notional principal for the same amount of time at the same specified dates. In a classic interest swap, otherwise known as plain vanilla interest swap, the same currency is used to pay the two cash flows. The payment dates which have been predetermined are known as settlement dates, and the time between them is the settlement period. As swaps are customized contracts, payments can be made monthly, quarterly, annually, or at any interval determined by the parties.
  • Currency Swaps: In a currency swap, both parties exchange principal and interest payments on debt that is denominated in different currencies. Unlike an interest rate swap, the principal is often not a notional amount but is instead exchanged along with interest obligations. Currency swaps can take place in different countries. For instance, Argentina and China have used this swap, particularly so China can stabilize its foreign reserves. As a second example, even the federal reserve of the USA has engaged in an aggressive currency swap strategy with European central banks. This was done during the 2010 financial crisis in Europe which was meant to stabilize the euro that had been falling as a result of the Greek debt crisis.
  • Total Returns Swap: In total returns swap trading, the total return from a particular asset is swap for a fixed interest rate. The party that will be paying the fixed rate exposure towards the underlying asset, be it a stock or an index. For instance, an investor can pay a fixed rate toward one party in return for capital appreciation in addition to dividend payments of a pool of stocks.
  • Commodity Swaps: The exchange of a floating commodity price is what is observed in a commodity swap. Take for example the spot price of Brent Crude oil, for a price that is set over an agreed-upon period. As suggested by the example, a commodity swap will most often involve crude oil.
  • Debt-Equity Swaps: As the name suggests, a debt-equity swap involves the swapping of equity for debt and vice versa. When it comes to a publicly-traded company, this would mean exchanging bonds for stocks. Debt-equity swaps are a means for a company to refinance its debt as well as relocate its capital structure.
  • Credit Default Swap (CDS): CDS or credit default swap trading comprises an agreement by a single party to pay the principal amount that is lost as well as the interest on a loan to the CDS buyer, provided the borrower defaults on their loan. Poor risk management and excessive leverage in the CDS market were major contributing causes to the financial crisis of 2008.

The Bottom Line

A swap in the financial world refers to a derivative contract where one party will exchange the value of an asset or cash flows with another. Take for example a company that is paying a variable interest rate might swap its interest payments with another company that will then pay a fixed rate to the first company. Swaps can also be utilized to exchange other types of risk or value such as the potential for a credit default in a bond.

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