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FD/U3 Topic 12 Swaps: Concept Characteristics and Types

In finance, a SWAP is a derivative in which two counterparties agree to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. Conventionally they are the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed.

A swap is an agreement to exchange one stream of cash flows for another. Swaps are most usually used to:

  • Switch financing in one country for financing in another
  • To replace a floating interest rate swap with a fixed interest rate (or vice versa)

In August 1981 the World Bank issued $290 million in euro-bonds and swapped the interest and principal on these bonds with IBM for Swiss francs and German marks. The rapid growth in the use of interest rate swaps, currency swaps, and swaptions (options on swaps) has been phenomenal. Currently, the amount of outstanding interest rate and currency swaps is almost $6 trillion. Recently, swaps have grown to include currency swaps and interest rate swaps. It can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

Different Types of Swaps

  1. Currency Swaps

Cross currency swaps are agreements between counter-parties 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 match 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.

They are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

  1. Credit Default Swap

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 bond.

  • 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 is defaulted.
  • 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 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.

As Warren Buffett calls them “financial weapons of mass destruction”. The credit default swaps are being blamed for much of the current market meltdown.

Example of Credit Default Swap;

  • An investment trust owns £1 million corporation bond issued by a private housing firm.
  • If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
  • The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
  • If the private housing firm doesn’t default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
  • If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
  • Therefore the hedge fund takes on a larger risk and could end up paying £1million

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Credit default swaps are used not only by investment banks, but also by other financial institutions. Corporate entities use credit default swaps either for protection purposes, to hedge or to sell. Investment banks are primarily affected by the buyers. If a number of major corporate entities have bought protection from the same investment bank, and all of them fail simultaneously, this will put pressure on the investment bank to pay out. Moreover, the credit risk caused by the above failure may lead to other risks, such as liquidity risk, market risk and operational risk. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants. The derivatives do not reduce credit risk, but rather transfer it from banks to other banks or entities. Therefore, most of the investment banks re-sell the sold protection on the market to other market participants.

  1. 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 are dependent on the price of an underlying commodity. 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.

They are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices.

A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. There are two kinds of agents participating in the commodity markets: end-users (hedgers) and investors (speculators).

Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market.

  1. 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 actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.

Equity swaps make the index trading strategy even easier. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios

The equity swap is the best swap amongst all the other swaps as it being an over-the-counter derivatives transaction; they have the attractive feature of being customizable for a particular user’s situation. Investors may have specific time horizons, portfolio compositions, or other terms and conditions that are not matched by exchange-listed derivatives. They are private transactions that are not directly reportable to any regulatory authority.

A derivatives dealer can, through a foreign subsidiary in the particular country, invest in the foreign securities without the withholding tax and enter into a swap with the parent dealer company, which can then enter a swap with the American investor, effectively passing on the dividends without the withholding tax

  1. Interest Rate Swap

An interest rate swap, or simply a rate swap, is an agreement between two parties to exchange a sequence of interest payments without exchanging the underlying debt. In a typical fixed/floating rate swap, the first party promises to pay to the second at designated intervals a stipulated amount of interest calculated at a fixed rate on the “notional principal”; the second party promises to pay to the first at the same intervals a floating amount of interest on the notional principle calculated according to a floating-rate index.

The interest rate swap is essentially a strip of forward contracts exchanging interest payments. Thus, interest rate swaps, like interest rate futures or interest rate forward contracts, offer a mechanism for restructuring cash flows and, if properly used, provide a financial instrument for hedging against interest rate risk.

The reason for the exchange of the interest obligation is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. In an interest rate swap they consist of streams of interest payments of one type (fixed or floating) exchanged for streams of interest payments of the other-type in the same currency.

Interest rate swaps are voluntary market transactions by two parties. In an interest swap, as in all economic transactions, it is presumed that both parties obtain economic benefits. The economic benefits in an interest rate swap are a result of the principle of comparative advantage. Further, in the absence of national and international money and capital market imperfections and in the absence of comparative advantages among different borrowers in these markets, there would be no economic incentive for any firm to engage in an interest rate swap.

Differential information and institutional restrictions are the major factors that contribute to the differences in transactions costs in both the fixed-rate and the floating-rate markets across national boundaries which, in turn, provide economic incentive to engage in an interest rate swap.

Interest rate swaps have become one of the most popular vehicles utilized by many companies and financial institutions to hedge against interest rate risk. The growing popularity of interest rate swaps is due, in part, to the fact that the technique is simple and easy to execute. The most widely used swap is a fixed/floating interest rate swap.

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