Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific period. Swaps provide great flexibility in designing and structuring contracts based on mutual agreement. This flexibility generates multiple swap variations, each serving a specific purpose.
There are several reasons for the parties to agree to such exchanges:
- The investment objectives or repayment scenario may have changed.
- Switching to new available or alternative cash flow streams can result in increased financial gains.
- The need may arise to reduce or reduce the risk associated with floating rate loan repayment.
interest rate swap
The most popular type of swaps are plain vanilla interest rate swaps. They allow two parties to exchange fixed and temporary cash flows on interest-bearing investments or loans.
Businesses or individuals strive to secure cost-effective loans but their selected markets may not provide the preferred loan solution. For example, an investor may get cheaper loans in the floating rate market, but they prefer a fixed rate. Swapping the interest rate allows the investor to switch the cash flows at will.
Let’s say Paul prefers a fixed rate loan and has loans available at either a floating rate (LIBOR + 0.5%) or a fixed rate (10.75%). Mary prefers floating rate loans and has loans available at either floating rate (LIBOR+0.25%) or fixed rate (10%). Due to the superior credit rating, Mary has an advantage over Paul in both the floating rate market (0.25%) and the fixed rate market (0.75%). He
The profit is high in the fixed rate market so she takes the fixed rate loan. However, since she prefers floating rate, she enters into a swap contract with a bank to pay the LIBOR and get a fixed rate of 10%.
Paul borrows on floating (LIBOR + 0.5%), but since he prefers fixed, he enters into a swap contract with the bank to pay 10.10% and get the floating rate.
the profit: Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives the LIBOR from the bank. His net payout is 10.6% (fixed). The swap effectively converted their original floating payment into a fixed rate, giving them the most economical rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. His net payout is LIBOR (floating). The swap effectively converted his original fixed payout to the desired floating one, giving him the most economical rate. The bank deducts 0.10% from the amount received from Paul and pays to Mary.
The transaction value of capital changing hands in money markets is higher than in all other markets. Currency swaps provide an effective way to hedge foreign exchange risk.
Let’s say an Australian company is setting up a business in the UK and needs 10 million GBP. Assuming that the AUD/GBP exchange rate is 0.5, the total amount is 20 million AUD. Similarly, a UK company wants to set up a plant in Australia and needs AUD 20 million. The cost of loans in the UK is 10% for foreigners and 6% for locals, while in Australia it is 9% for foreigners and 5% for locals. Apart from the high loan cost for foreign companies, it may be difficult to obtain loans easily due to procedural difficulties. Both companies have a competitive advantage in their domestic debt markets. An Australian firm can take a low-cost loan of AUD 20 million in Australia, while an English firm can take a low-cost loan of GBP 10 million in the UK. Let’s say both loans require six monthly repayments.
The two companies then execute a currency swap agreement. Initially, the Australian firm gives AUD 20 million to the English firm and receives GBP 10 million, allowing both firms to start business in their respective foreign lands. Every six months, the Australian firm pays the interest payment for the English loan to the English firm = (notional GBP amount * interest rate * duration) = (10 million * 6% * 0.5) = GBP 300,000 while the English firm pays the Australian firm Pays the interest payment for the Australian loan = (Estimated AUD amount * Interest rate * Duration) = (20 million * 5% * 0.5) = AUD 500,000. Interest payments continue until the end of the swap agreement, at which time the original notional foreign currency amounts will be exchanged back to each other.
the profit: By engaging in a swap, the two firms were able to secure low-cost loans and hedge against interest rate fluctuations. Variations also exist in currency swaps, including fixed versus floating and floating versus floating. In short, the parties are able to hedge against volatility in foreign exchange rates, secure better lending rates, and obtain foreign capital.
Commodity swaps are common between individuals or companies that use raw materials to produce goods or finished products. If commodity prices change, profits from the finished product may be affected, as production prices may not change in sync with commodity prices. Commodity swaps allow the realization of a payment linked to the price of the commodity against a fixed rate.
Let’s say two parties get into a commodity swap worth more than one million barrels of crude oil. One party agrees to make six-monthly payments at a fixed price of $60 per barrel and receive the current (provisional) price. The other party will receive the fixed rate and make a provisional payment.
If crude oil rises to $62 at the end of six months, the first party will be liable to pay the fixed ($60 * 1 million) = $60 million and the second party will be liable to pay the variable ($62 * 1 million) = will receive $62 million. In this scenario the net cash flow transferred from the second party to the first would be $2 million. Alternatively, if crude falls to $57 in the next six months, the first party will pay the second party $3 million.
the profit: The first party locks in the price of the commodity by obtaining a price hedge, using a currency swap. Commodity swaps are effective hedging tools against changes in commodity prices or against changes in spreads between the prices of the final product and raw materials.
credit default swaps
Credit default swap provides insurance in case of default by a third party borrower. Let’s say Peter founded ABC, Inc. 15 years long bond issued by The bond costs $1,000 and pays interest of $50 annually (ie a 5% coupon rate). Peter worries that ABC, Inc. Default can happen so he executes a credit default swap agreement with Paul. Under the swap agreement, Peter (the CDS buyer) agrees to pay Paul (the CDS seller) $15 per year. Paul ABC, Inc. Trusts and is ready to take the default risk on your behalf. For a $15 receipt per year, Paul will offer Peter insurance for his investments and returns. If ABC, Inc. If defaults, Paul will pay Peter $1,000 plus any remaining interest payments. If ABC, Inc. If the bond does not default during the longer bond term of 15 years, Paul benefits from keeping $15 per year without paying Peter.
the profit: CDS acts as an insurance to protect lenders and bondholders from default risk of borrowers.
zero coupon swap
Similar to interest rate swaps, zero coupon swaps provide flexibility to one party in a swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flow is not paid out periodically, but only once at the end of the swap contract’s maturity. The other party that pays the floating rate continues to make regular periodic payments following the standard swap payment schedule.
A fixed-fixed zero coupon swap is also available, in which one party does not make any interim payments, but the other party continues to make fixed payments as per schedule.
the profitZero Coupon Swaps (ZCS) are primarily used by businesses to hedge debt in which interest is paid on maturity or banks that issue bonds with interest payments at the end of the maturity period.
total return swap
A total return swap gives an investor the advantage of owning…