Swaps: What you Need to Know

What are Swaps?

• A swap is a financial maneuver (derivative) where counterparties exchange benefits of one party’s financial asset for those of the other party’s financial instrument. The exact exchange of benefits is dependent on the type of financial instruments involved; for example, when two bonds are swapped, the benefits can be the coupon attached to the bond (the periodic interest payments).

• More specifically, the counterparties involved in a swaps trade will agree to exchange one stream of cash flow against another source; these exchanged streams of revenue are referred to as the ‘legs’ of a swap.

• All swap trades are met with a swap agreement; in essence, this refers to the contract of the exchange were the dates and calculations of the exchange are affirmed. In most swaps, these variables are typically determined by an uncertain market calculation, such as the interest rate, the foreign exchange rate or the price of the underlying commodity or equity.

• Cash flows of swaps are calculated over a notional principal figure, which is typically not exchanged at the time the counterparties agree on the swap. As a result of this, swaps can be initiated in cash or as collateral.


How are Swaps Traded?

• The majority of swaps are traded over-the-counter; however, some swaps may be exchanged on a future market. The Bank for International Settlements is responsible for publishing statistics on the notional amounts of outstanding swaps in the OTC derivatives market.


Types of Swaps:

• There are five basic types of swaps: interest rate swaps, credit swaps, commodity swaps, equity swaps and currency swaps.

o The most basic type of swap is an interest rate swap. These swaps simply refer to the exchange of a fixed rate loan to a floating rate loan. The life of these swaps will range from 2 years to over 15 years; these types of swaps are meant to utilize comparative advantage. A company who has a comparative advantage in a fixed rate market can profit from enacting a swap with a company who has a comparative advantage in a floating rate market.

o Currency Swaps: A currency swap involves the exchange of principal and a fixed interest payment on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Similar to interest rate swaps, the currency swap is motivated by comparative advantage.

o Commodity Swaps: A commodity swap is an agreement where a floating price is exchanged for a fixed price over a solidified timeframe. Commodity swaps, in the majority of instances, will involve crude oil swaps.

o Equity Swaps: Equity swaps are a type of total return swap, where the underlying asset is a stock, a stock index or a basket of stocks. As oppose to actually owning the stock, the party will not have to pay anything up front to partake in equity swaps. Those who initiate equity swaps will not be granted any voting or other rights that are realized in traditional stock ownership.

o Credit Default Swaps: A credit default swap is a type of contract where the buyer of the Credit Default Swap makes a series of payments to the seller and, in exchange, receives a credit instrument.