Swaps

Swap, in finance, refers to a derivative product in which the parties to the contract agree to exchange cash flows of each other’s financial instruments. The benefits arising out of a swap contract depend upon the type of financial instruments whose cash flows are to be swapped. If a swap involves two bonds, then the benefits are the periodic interest payable on the bonds or a coupon that can be redeemed. A swap is a typical tradable derivative product in which one stream of cash flows is agreed to be exchanged with another stream by the counterparties involved. The streams of cash flows are called the legs of the swap.

A typical swap contract defines the method of calculation of the cash flows and the dates on which they are to be paid. While determining the series of cash flows at the time of initiation of the contract, at least one of these series involves a variable such as price of a stock or commodity, interest rate or foreign exchange rate.

Although the basis of calculation of cash flows is a notional principal amount, unlike derivative products such as futures, forward contract and option the notional amount is normally not exchanged between the counterparties. As a result, a swap contract may be in cash or collateral.

Swaps are commonly used for hedging risks like interest rate risk and for speculating on the price movements of underlying assets.

As compared to some other derivatives products, swaps are a relatively new introduction. The first swap was reported between IBM and the World Bank when, in 1981, they entered into a swap agreement. Ever since, swaps have gained immense popularity and are now one of the most heavily traded contracts in the financial markets. As per data released by the International Swaps and Derivatives Association, the total amount of outstanding swaps in interest rates and currency in 2009 was more than $ 426.7 trillion.

The Swap Market

Swaps are usually customized for the counterparties and most of them are traded over the counter. However, exchanges such as Chicago Mercantile Exchange Holdings Inc., the Chicago Board Options Exchange, Intercontinental Exchange and Eurex AG offer some types of swaps for trade on their platforms.

Statistics regarding notional amounts outstanding in the over-the-counter derivatives markets are published periodically by the Bank of International Settlements (BIS). As per figures released by it, the total outstanding amount in December 2006 was US$ 415.2 trillion, which was more than 8.5 times the gross world product. Out of this, interest rate swaps amounted to US$ 292.0 trillion, which is more than fifty percent of the total. However, although the cash flows generated by swaps are equal to a substantial fraction of the gross world product (which also a measure of cash flow), the actual amount is much less because cash flows swaps are but a small percentage (for example, interest rate) of the notional amount.

Currency-wise notional amounts were the largest in euro and lowest in Swiss franc. The figures at the end of 2006 were as follows:

• Euro: US$ 112 trillion, a jump of more than 37% over 2005 and more than six times that of 2000
• US dollar: US$ 97.6 trillion, an increase of more than 31% over 2005 and more than seven times that of end 2000
• Japanese yen: US$ 38.0 trillion, a jump of more than 48% over 2005 and more than three times that of end 2000
• Pound sterling: US$ 22.3 trillion, nearly 48% increase over 2005 and more than more than five times that of end 2000
• Swiss franc: US$ 3.5 trillion, which was more than double the end 2000 figure but only fractionally higher than that of 2005

Normally, at least one leg of a swap is a variable rate, which may be the total return of a swap, a reference rate, an economic statistic etc. What is important is that the source of the variable is an independent trade authority such as LIBOR published by the British Bankers Association, something that helps in avoiding conflict of interest.

Swap Types

There are five types of generic swaps.

Interest Rate Swaps

Interest rate swaps are quantitatively the most important type of swaps, the most common being the “plain Vanilla” interest rate swap. This involves exchanging a fixed rate loan swap to a floating rate loan. The swap may remain ‘live’ for any period ranging from two to fifteen years or more. Companies want to borrow cheap but they sometimes have to settle for a floating rate despite the fact that they perceive that they have a comparative advantage in fixed rate.

Suppose party A has a loan at LIBOR + 1.5%, which a variable interest rate and party B has a fixed rate loan at 8.5% per annum. A swap contract between the two effectively transforms the variable interest rate loan into a fixed rate loan. Payments are calculated on the notional amount and party A pays periodic interest payments to party B at the variable rate of LIBOR + 1.5% and in return, party B makes interest payments based on the fixed rate of 8.5%. In actual practice however, parties do not make direct payments to each but each party sets up a separate swap with an intermediary bank, which takes a spread from the swap payments. This means that the actual rate paid by each is slightly more due to the spread taken by the bank.

Currency Swaps

Currency swaps involve swapping of principal as well as fixed interest rate payments but the loans and interest payments of the counterparties are in different currencies. The motive in this case is also the comparative advantage that one borrower enjoys in one currency over the other. Cash flows are in the two currencies involved in the swap and the exchange rate is the variable factor in this case.

Credit Swaps

These are actually credit default swaps and more in nature of insurance. In a credit swap, one party makes a series of payments to the other. In exchange, the party making the payment receives a payoff in the event of the underlying instrument, typically a loan or a bond, fails to pay. In most cases, a payoff results in the event of a company undergoing restructuring, getting its credit rating downgraded or bankruptcy. Comparison with insurance is due to the fact that the buyer makes regular payments (as in a premium on an insurance policy) in return of occurrence of any one of the events specified in the contract. However, unlike insurance, the buyer of a credit default swap can make a profit from the contract and may also relate to an asset in which the buyer does not have a direct exposure.

Commodity Swaps

In commodity swaps the variable is the market price of the commodity. The exchange in this case is between this floating leg of the swap and a fixed rate of underlying commodities such as oil and sugar. Quantitatively, crude oil swaps form the biggest chunk of all commodity swaps.

Equity Swaps

These relate to stocks with dividend payments being the variable.

Variations

The vanilla swap can be restructured in as many ways as the financial engineers can imagine. The underlying motive is almost always to derive a comparative advantage.

• Total return swap: In this, one party pays the total return of an asset, which is the capital gain or loss plus any interest or dividend. The other party to the contract makes periodic interest payments. In the event that the total return is negative, the party making paying total return receives the amount from the other party. Both parties are exposed to the return of the underlying asset (stock or index) without actually holding the asset. For the party making periodic payments, the profit or loss is the same as from actually owning the asset.
• Amortizing swap: It is a typical interest rate swap where the notional principal amount for interest payments declines over the swap’s life, maybe at a rate connected with the prepayment of a mortgage or to an interest rate benchmark such as LIBOR. Amortizing swaps are preferred by individuals and businesses that need to manage the interest rate risk in investment programs and anticipated funding requirement.
• Swaption: This swap gives one party the right but not the obligation to enter into a particular swap agreement at a future date.
• Variation swap: This swap is available over the counter and allows hedging risks or speculating on the magnitude of a movement. A similar swap lets the purchaser fix the duration of the flows received on a swap.
• Zero Coupon Swap: Organizations that need to maintain cash balances for operational purposes but with liabilities that attract floating rates can make use of a zero coupon swap.
• Deferred rate swap: This type of swap benefits those who need funds immediately but are vary of the current interest rates and anticipate a fall in future interest rates.
• Accreting swap: These are used primarily by banks that have made large commitments to their customers to lend them money for funding their projects.
• Forwards swap: A forward swap may be a forward start swap, forward deferred start swap or a delayed start swap. It is an agreement born out of a combination of two swaps with different durations created with the intention f meeting an investor’s time-frame needs.

Valuation

A swap is valued on the basis of the net present value (NPV) of approximated future cash flows. At the time of its initiation, the valuation of a swap is zero. However, with passage of time, it may acquire a value, which may be positive or negative. Swaps are generally valued in two ways:

Valuation in Terms of Bond Prices

Swap value does not change in an interest rate swap where the principal amount is not exchanged, assuming that these are paid and received at the end of the swap. Therefore, for a floating rate payer’s point of view, the swap value is equal to a long position in a fixed-rate bond and short position in a floating rate note.

From the perspective of a fixed rate payer, the swap value can thus be viewed as being the opposite of the above.

Going by the same principle, the value of a currency swap is equivalent to the positions in bonds whose cash flows match to those in the swap. The home currency value of a currency swap is:

where represents cash flows of the domestic asset and the cash flows of the foreign asset.

LIBOR is the London Interbank Offered Rate, the interest rate on loans between banks in the Eurocurrency market. A one-month LIBOR is the interest rate for 1-month deposits and three-month LIBOR is for deposits for three month duration.

Money trading between banks determines LIBOR rates, which are continuously changing and normally depend upon current economic situation. The LIBOR rate is a reference rate for the international market just as the prime rate refers to interest rates quoted in the domestic market.

Arbitrage

Arbitrage opportunities in swap exist only when there is a value ascribed to the contract. As mentioned above, inherently all swaps are valued at zero at the time of their creation.

Example

Suppose, in a plain vanilla fixed-to-floating interest rate swap party A pay a fixed interest rate and party B pays a floating interest rate. In such a contract, the NPV value of the swap is zero because the present value of the future fixed rate payments payable by party A are equal to the expected future floating rate payments.

A third party, the arbitrageur, may enter only when this is not the case. Where the swap has a value, the arbitrageur can:

• borrow funds equal to the present value of the lower present value of payments
• use the borrowed funds for meeting the cash flow obligations on the position and receive the corresponding payments; the present value of these are obviously higher
• use the payments received to repay the borrowed funds and,
• pocket the difference, which is the difference between the present value of the borrowed funds and the arbitrage profit (payments of higher present value received less payments of lower present made)

Later, once the swap has been traded, the swap price must equate to the corresponding instruments as mentioned above. In case this is not true, the arbitrageur may short sell the instrument that is overpriced and use moneys received for buying the instrument that is priced correctly and pocket the difference. The money thus generated can then be used to service the instrument that was shorted for financing the trade.