Swap

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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.

The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

Contents

Structure

A swap is an agreement between two parties to exchange future cash flows according to a prearranged formula. They can be regarded as portfolios of forward contracts. The streams of cash flows are called “legs” of the swap. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange and Frankfurt-based Eurex AG. David Swensen, a Yale Ph.D. at Salomon Brothers, engineered the first swap transaction according to "When Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger Lowenstein.

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product -- which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as:

Notional outstanding
in USD trillion
Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0
Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1], "OTC Derivatives Market Activity in the Second Half of 2006", BIS, [2]

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent trade body.

Example

Take the case of a plain vanilla fixed-to-floating interest rate swap. Here party A makes periodic interest payments to party B based on a variable interest rate of LIBOR +50 basis points.

Party B in turn makes periodic interest payments based on a fixed rate of 3%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR.

Total return swap

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A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.

A total return swap (also known as total rate of return swap, or TRORS) is a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness of the reference asset, especially where the payments are based on the same notional amount. The reference asset may be any asset, index, or basket of assets.

The TRORS, then, allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (which does retain that asset on its balance sheet) to buy protection against a potential decline in its value.

The essential difference between a TRORS and a credit default swap is that the latter provides protection not against loss in asset value but against specific credit events. In a sense, a TRORS isn’t a credit derivative at all, in the sense that a credit default swap is. A TRORS is funding-cost arbitrage.

Equity Swap

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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. 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.

Valuation

The value of a swap is the net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future cash flows is equal to zero.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

  1. assume the position with the lower present value of payments, and borrow funds equal to this present value
  2. meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
  3. use the received payments to repay the debt on the borrowed funds
  4. pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

See: Rational pricing; Arbitrage

Variations

Variations of swaps include cross currency swaps, amortising swaps and so on.

Interest Rate Swaps

Template:Main The most common type of swaps is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange 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.

London Interbank Offered Rate (LIBOR)

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LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the International Market.

Currency Swaps

The Currency Swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps also are motivated by comparative advantage.

Options

An option on a swap is called a swaption.

References

  • Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006

See also

External links

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