What are Swaps?
A derivatives contract is one of the best diversification and trading instruments used by both investors and traders. Based on its structure, it can be broadly divided into the following two categories; Contingent claims, otherwise known as options and forward claims, such as exchange-traded futures, swaps, or forward contracts. From these categories, swap derivatives are effectively used to exchange liabilities. These are an agreement between two parties to exchange a sequence of cash flows over a certain duration.
What Is Swap Trading?
A swap Derivative is a contract wherein two parties decide to exchange liabilities or cash flows from separate financial instruments. Often, swap trading is based on loans or bonds, otherwise known as a notional principal amount. However, the underlying instrument used in Swaps can be anything as long as it has a legal, financial value. Mostly, in a swap contract, the principal amount does not change hands and stays with the original owner. While one cash flow may be fixed, the other remains variable and is based on a floating currency exchange rate, benchmark interest rate, or index rate.
Typically, at the time someone initiates the contract, at least one of these cash flows is determined through an uncertain or random variable, like foreign exchange rate, interest rate, equity price, or a commodity price.
How does Swap Trading Works?
Essentially, Swap Trading works when two parties agree to swap their cash flows or liabilities based on two separate financial instruments. Although there are many types, the most common kind of swap is known as an interest rate swap. A swap is not standardised and does not trade on public stock exchanges, and it is not common for retail investors to engage in a swap.
Instead, swaps are contracts that are traded over-the-counter primarily between financial institutions or businesses. Since they are traded over-the-counter, the terms of the swap contract are negotiated and customised 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, the swap contracts are considered risky because of the counterparty risk where one party can default on the payment.
Types Of Swaps
Countless variations exist in exotic swap agreements. Some of the most common swap contracts are as follows:
- Interest Rate Swaps: The idea behind an interest rate swap is to switch the cash flows from a fixed interest rate to a floating interest rate. In such a swap, Party A agrees to pay a fixed rate of interest to Party B on a notional principal for a specified period and on predetermined intervals.
For instance, Argentina and China have used this swap, allowing China to stabilise its foreign reserves. Another example is the use of currency swaps by the federal reserve of the USA engaging in aggressive currency swap agreements with European central banks. This was done during the 2010 financial crisis in Europe to stabilise the euro that had been falling as a result of the Greek debt crisis.
- Currency Swaps: In a currency swap, both parties exchange principal and interest payments on debt that is denominated in different currencies agreed by the parties. Unlike an interest rate swap, the principal is often not a notional but is exchanged along with interest obligations. Currency swaps can take place between different countries.
Consequently, Party B agrees to make payments to Party A on a floating interest rate with the same notional principal, the same amount of time, and the same intervals. The same currency is used to pay the two cash flows in a classic interest swap, otherwise known as a plain vanilla interest swap. The predetermined payment dates are known as settlement dates, and the time between them is called the settlement period. As swaps are customised contracts, payments can be made monthly, quarterly, annually, or at any interval determined by the parties.
- Total Returns Swap: In total returns swaps, the total return from a particular asset is swapped for a fixed interest rate. The party that pays the fixed rate takes on the exposure towards the underlying asset, be it a stock or an index. For instance, an investor can pay a fixed rate to a party in return for exposure to stocks, realising the capital appreciation and earning the dividend payments, if any.
- Commodity Swaps: Commodity swaps are used to exchange cash flows that are dependent on a commodity price. As the price of commodities is floating, one party exchanges this floating rate for a fixed rate. For example, a producer can swap the spot price of Brent Crude oil for a price that is set over an agreed-upon period. It allows producers to lock in a set price and mitigate losses based on future price fluctuations.
- Debt-Equity Swaps: A debt-equity swap involves the swapping of equity for debt and vice versa. It is a financial restructuring process where one party exchanges/cancels another party’s debt in exchange for an equity position. For 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 swaps is an agreement by a party that offers insurance to the second party if a third party defaults on a loan offered by the second party. The first party offers 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.
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. 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 utilised to exchange other types of risk or value, such as the potential for a credit default in a bond.