A swap as a financial instrument refers to a notional principal contract in which one party undertakes to make payments to the other party using a specified variable rate, the notional amount. On the other hand, the other party undertakes to make regular payments, which would, be based on a different rate or index in application to the notional amount. In other words, swaps refer to derivatives in which the parties engage in the exchange of cash flows hence the term swap. The benefits inherent in a swap depend on the kind of financial instrument exchanged. The agreement of the swap includes the dates of payments of the cash flows and the calculations. Swaps vary in types and include diverse and ranging alternatives covering elements like period payments, termination payments, prepayments, options to enter into other swaps and contingent payments.
Some of the main swaps available in markets internationally include the following: interest rate swap, equity swaps, currency swaps, credit swaps, commodity swaps.
A typical interest rate swap is the plain Vanilla interest rate swap. This swap allows the exchange of a fixed rate loan with a floating rate loan. The exchange allows the parties to benefit from comparative advantage. This would arise where one party has comparative advantages in the floating rate markets, and the other party has advantages in the fixed rate markets. The companies, when seeking for cheaper sources of borrowing, would opt for sources that avail comparative advantage to them. They would then swap the interest at their own convenience. Therefore, the swap has the effect of changing a fixed rate loan to one with a floating rate or the converse. The following is a basic example of a plain Vanilla fixed to a floating interest rate swap: party A obliges to payment of an amount equal to seven percent on two million dollars annually for five years. Party B in turn obliges to pay an amount equal to LIBOR plus two percent on two million dollars annually for five years.
Currency swaps, on the other hand, entail the exchange of the principal and fixed rate interest payments of a loan in one currency for equal loan in the other currency. The motivation lies in the comparative advantages that accrue with the respective currencies. For instance, the comparative advantage that may accrue with the currency swap could be the conversion of an existing debt from one currency to another currency or the conversion of an existing asset from one currency to the other.
Credit default swaps refers to contracts under which the purchaser remits a series of payments to the seller, who in return gives a payoff if the financial instrument defaults. In essence, the buyer of the credit default swap covers himself against the effect of the financial instrument defaulting. It, therefore, borrows from the concept of insurance where the buyer’s series of payments can be equated to premiums and the payoff equated to compensation.
Commodity swaps essentially refer to the contract whereby the floating, market or spot price that is based on the underlying commodity such as crude oil is exchanged for a fixed price over a specified period. No actual commodities are exchanged during the trade. However, it involves the user of the commodity securing a maximum price and agreeing to pay the financial institution at that fixed price.
How swaps reduce risks
Swaps provide a convenience for the parties that engage in the swap. The main motivation, however, lies in the comparative advantages that accrue from the respective swaps. The risks inherent in various financial instruments are effectively reduced through the use of specific swaps that address the particular risks. Take for instance the credit default swap, the buyer remits the series of payment to cushion his finances from adverse financial losses that would occur of the financial instrument defaults. As such, he would receive the payment upon default of the instrument hence effectively limits the likely risks of financial loss. On the other hand, a plain Vanilla exchange interest rate swap enables one party to avoid the inconveniences of the floating interest rate loans and enjoy the advantages of the fixed interest rate loans. The risks reduction should be seen in light of the benefits that accrue due to comparative advantages. The borrowing sources would be convenient and less risky for the firm depending on his actual source. He then transfers this kind of interest rate to the other party.
Swap rates refer to the actual fixed rate that is used in setting the market value of the respective swap at the initiation. The swap rates are calculated with the use of the first rate leg of the respective swap. The swap rate is mathematically equal to the risk free interest rate plus the interest rate risk of the swap. It, therefore, shows the market value of the swap. The leg of the swap refers to the streams of cash flows.
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Flavell, R. R. (2012). Swaps and Other Derivatives. New York: John Wiley & Sons.
Neftci, S. N. (2008). Principles of Financial Engineering. New York: Academic Press.
Sadr, A. (2009). Interest Rate Swaps and Their Derivatives:A Practitioner's Guide. New York: John Wiley & Sons.