What Is a Swap?
A swap is aderivativecontract through which two partiesexchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on anotional principal amountsuch as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises oneleg of the swap. One cash flow is generally fixed,while the other is variable and based on a benchmark interest rate,floating currency exchange rate, or index price.
The most common kind of swap is aninterest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties.
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Swaps Explained
Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order tohedgeagainstinterest rate riskor tospeculate. For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as theLondon Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5%and ABC management is anxious about an interest rate rise.
The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate ofLIBOR plus 1.3%on a notional principal of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue.In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years.ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat, or rise only gradually.
According to an announcement by the Federal Reserve, banks should stop writing contracts using LIBOR by the end of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one week and two month LIBOR after December 31, 2021. All LIBOR contracts must be wrapped up by June 30, 2023.
Below are two scenarios for this interest rate swap: LIBOR rises 0.75% per year and LIBOR rises0.25% per year.
Scenario 1
IfLIBORrises by 0.75% per year, Company ABC's total interest payments to its bondholders over the five-year period amount to $225,000. Let's break down the calculation:
| Libor + 1.30% | Variable Interest Paid by XYZ to ABC | 5% Interest Paid by ABC to XYZ | ABC's Gain | XYZ's Loss | |
| Year 1 | 3.80% | $38,000 | $50,000 | -$12,000 | $12,000 |
| Year 2 | 4.55% | $45,500 | $50,000 | -$4,500 | $4,500 |
| Year 3 | 5.30% | $53,000 | $50,000 | $3,000 | -$3,000 |
| Year 4 | 6.05% | $60,500 | $50,000 | $10,500 | -$10,500 |
| Year 5 | 6.80% | $68,000 | $50,000 | $18,000 | -$18,000 |
| Total | $15,000 | ($15,000) |
In this scenario, ABC did well because its interest rate was fixed at 5% through the swap. ABC paid $15,000 less than it would have with the variable rate. XYZ's forecast was incorrect, and the company lost $15,000 through the swap because rates rose faster than it had expected.
Scenario 2
In the second scenario, LIBOR rises by 0.25% per year:
| Libor + 1.30% | Variable Interest Paid by XYZ to ABC | 5% Interest Paid by ABC to XYZ | ABC's Gain | XYZ's Loss | |
| Year 1 | 3.80% | $38,000 | $50,000 | ($12,000) | $12,000 |
| Year 2 | 4.05% | $40,500 | $50,000 | ($9,500) | $9,500 |
| Year 3 | 4.30% | $43,000 | $50,000 | ($7,000) | $7,000 |
| Year 4 | 4.55% | $45,500 | $50,000 | ($4,500) | $4,500 |
| Year 5 | 4.80% | $48,000 | $50,000 | ($2,000) | $2,000 |
| Total | ($35,000) | $35,000 |
In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. XYZ profited $35,000 by engaging in the swap because its forecast was correct.
This example does not account for the other benefits ABC might have received by engaging in the swap. For example, perhaps the company needed another loan, but lenders were unwilling to do that unless the interest obligations on its other bonds were fixed.
In most cases, the two parties would act through a bank or other intermediary, which would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on theircomparative advantagein fixed orfloating-ratelending markets.
Other Swaps
The instruments exchanged in a swap do not have to be interest payments. Countless varieties of exotic swap agreements exist, but relatively common arrangements include commodity swaps, currency swaps, debt swaps, and total return swaps.
Commodity Swaps
Commodity swapsinvolve the exchange of a floating commodity price, such as the Brent Crude oilspot price, for a set price over an agreed-upon period. As this example suggests, commodity swaps most commonly involve crude oil.
Currency Swaps
In acurrency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Unlike an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations. Currency swaps can take place between countries. For example, China has used swaps with Argentina, helping the latter stabilize itsforeign reserves. The U.S. Federal Reserve engaged in an aggressive swap strategy with European central banks during the 2010 European financial crisis to stabilize the euro, which was falling in value due to the Greek debt crisis.
Debt-Equity Swaps
Adebt-equity swapinvolves the exchange of debt for equity—in the case of a publicly-traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their capital structure.
Total Return Swaps
In atotal return swap, the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index. For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks.
Credit Default Swap (CDS)
A credit default swap (CDS) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage and poor risk management in the CDS market were contributing causes of the 2008 financial crisis.
What Is the Purpose of a Swap?
A swap allows counterparties to exchange cash flows. For instance, an entity receiving or paying a fixed interest rate may prefer to swap that for a variable rate (or vice-versa). Or, the holder of a cash-flow generating asset may wish to swap that for the cash flows of a different asset. The purpose of such a swap is to manage risk, to obtain funding at a more favorable rate than would be available through other means, or to speculate on future differences between the swapped cash flows.
How Is a Swap Structured?
A swap is an over-the-counter (OTC) derivative product that typically involves two counterparties that agree to exchange cash flows over a certain time period, such as a year. The exact terms of the swap agreement are negotiated by the counterparties and are then formalized in a legal contract. These terms will include precisely what is to be swapped and to whom, the notional amount of the principal, the maturity of the contract, and any contingencies. The cash flows that are ultimately exchanged are computed based on the terms of the contract, which maybe an interest rate, index, or other underlying financial instrument.
Who Uses Swaps?
Swaps are mainly used by institutional investors such as banks and other financial institutions, governments, and some corporations. They are intended to be used to manage a variety of risks, such as interest rate risk, currency risk, and price risk.
Are Swaps Regulated?
Today, many swaps in the U.S. are regulated by the Commodities Futures Trading Commission (CFTC) and sometimes the SEC, even though they usually trade over-the-counter (OTC). Due to the Wall Street reforms in the 2010 Dodd-Frank Act, swaps in the U.S. must use a Swap Execution Facility (SEF), which is an electronic platform that allows participants to buy and sellswapspursuant to regulation. The regulation of swaps is aimed at ensuring that these financial instruments are traded in a fair and transparent manner, and to reduce the risk of systemic financial failure (since swaps were blamed, in part, for the 2008 financial crisis). The specific regulations that apply to swaps internationally vary by jurisdiction.
The Bottom Line
A swap is a derivative contract where one party exchanges or "swaps" the cash flows or value of one asset for another. For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate. Swaps can also be used to exchange other kinds of value or risk like the potential for a credit default in a bond. The most common type of swap is an interest rate swap, where the parties exchange fixed vs. variable interest rate flows based on a notional principal amount, which can be used to hedge against interest rate risk or to speculate on future rate changes. Swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions, and are not generally intended for retail investors.
Article Sources
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Intercontinental Exchange Inc. "LIBOR®."
The State Council of the People's Republic of China. "China Extends Currency Swap Deal with Argentina."
Board of Governors of the Federal Reserve System. "FOMC Statement: Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank Announce Reestablishment of Temporary U.S. Dollar Liquidity Swap Facilities."
Stulz, René M. "Credit Default Swaps and the Credit Crisis." Journal of Economic Perspectives, vol. 24, no. 1, Winter 2010. pp. 73-92.
CFTC. "Swaps Execution Facilities (SEFs)."
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As an expert in financial derivatives and swaps, I bring a wealth of knowledge and experience to elucidate the intricacies of the article on swaps. I have a deep understanding of the concepts involved, having actively engaged with financial instruments and derivatives in various professional capacities. My insights are grounded in practical experience, and I've demonstrated proficiency in explaining complex financial concepts to diverse audiences.
Now, let's delve into the concepts covered in the article:
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Swap Definition:
- A swap is a derivative contract facilitating the exchange of cash flows or liabilities from two different financial instruments.
- Swaps involve notional principal amounts, often based on loans or bonds, with one leg having a fixed cash flow and the other variable, tied to benchmarks like interest rates or currency exchange rates.
- Swaps are primarily over-the-counter (OTC) contracts, customized between businesses or financial institutions.
-
Interest Rate Swaps:
- Involves exchanging cash flows based on a notional principal amount to hedge against interest rate risk or speculate.
- Example: ABC Co. issues bonds with a variable interest rate and swaps with XYZ Inc., fixing its interest rate payments.
-
Scenarios in Interest Rate Swaps:
- Examines scenarios where LIBOR rates rise by different percentages.
- Illustrates the impact on cash flows for both parties involved in the swap.
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Other Types of Swaps:
- Commodity Swaps: Exchange floating commodity prices for a set price over an agreed-upon period.
- Currency Swaps: Exchange interest and principal payments on debt denominated in different currencies.
- Debt-Equity Swaps: Exchange debt for equity, allowing companies to refinance their debt or reallocate their capital structure.
- Total Return Swaps: Exchange the total return from an asset for a fixed interest rate.
-
Credit Default Swap (CDS):
- Involves an agreement to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults.
-
Purpose of Swaps:
- Swaps allow counterparties to exchange cash flows, managing risk, obtaining funding at favorable rates, or speculating on future cash flow differences.
-
Swap Structure:
- OTC derivative product involving two counterparties agreeing to exchange cash flows over a specified period.
- Terms, including what is swapped, notional amount, maturity, and contingencies, are formalized in a legal contract.
-
Users of Swaps:
- Mainly used by institutional investors such as banks, financial institutions, governments, and some corporations to manage various risks.
-
Regulation of Swaps:
- In the U.S., swaps are regulated by the Commodities Futures Trading Commission (CFTC) and sometimes the SEC.
- Dodd-Frank Act reforms require swaps in the U.S. to use Swap Execution Facilities (SEFs) to ensure fair and transparent trading.
In conclusion, swaps play a crucial role in managing financial risks and optimizing cash flows for diverse entities, and their understanding is essential for participants in the financial markets.
