What Are A Swaps?
It is possible to exchange the cash flows or liabilities of two separate financial instruments through a swap contract. As a general rule, most swaps are based on cash flows, although the instrument may be nearly anything. In most cases, the principle is not transferred. In the swap, each cash flow represents one leg. There are two types of cash flows: one is stable and based on the benchmark interest rate, and the other is variable and based on a floating currency exchange rate or an index price.
Interest rate swaps are the most prevalent kind of swap. However, trading in swaps is not available to regular investors, nor are swaps traded on exchanges. Instead, opt for OTC contracts that cater to the buyer and seller’s specific requirements, such as swaps.
Swaps Described in Detail
Swaps in Interest Rates
To hedge against interest rate risk or speculate, the parties in an interest rate swap exchange cash flows based on a notional principal amount (this amount is not exchanged). For example, ABC Company recently issued $1 million in five-year bonds with a variable annual interest rate specified as LIBOR + 1.3%. (or 130 basis points). Assume that LIBOR is 2.5% and that ABC’s management is concerned about an increase in interest rates.
For the next five years, XYZ Inc. is ready to pay ABC an annual rate of LIBOR + 1.3 percent on a notional principal of $1 million. According to ABC’s recent bond offering, XYZ will take care of ABC’s interest payments on its issued bonds. When ABC agrees to pay 5 percent annually for five years, XYZ gets $1 million. ABC gains from the exchange of interest rates climb considerably over the following five years. In XYZ’s favor is a lower, flat, or gradual increase in interest rates.
- As announced by the Federal Reserve, by the end of 2021, banks will no longer be able to write contracts using LIBOR. After December 31, 2021, LIBOR will no longer be published by the Intercontinental Exchange, which is responsible for LIBOR. By June 30, 2023, all LIBOR contracts must be terminated.
LIBOR will grow by 0.75 percent per year or by 0.25 percent per year in the two scenarios below.
This is Scenario 1!
It costs Company ABC $225,000 in interest payments to bondholders if LIBOR climbs by 0.75 percent each year. So let’s take a closer look at the numbers:
This was a win-win situation for ABC since the swap locked its interest rate at 5%. As a result, ABC saved $15,000 compared to the variable rate. However, since rates grew quicker than projected, XYZ’s prediction was inaccurate, and the business suffered a $15,000 loss on the exchange.
Libor climbs 0.25 percent annually in the second scenario.
Because interest rates climbed slowly, ABC would have been better off not participating in the exchange. However, due to its accurate projection, XYZ made $35,000 from the transaction.
It is not included in this example how ABC may have reaped further advantages from the trade. For instance, it’s possible that lenders were hesitant to lend to the corporation unless its interest commitments on its other debts could be guaranteed.
Most of the time, a bank or other third party acts as a go-between for the two sides, taking a percentage of the trade. Whether a fixed-rate or a floating-rate interest rate swap is desirable for two parties relies on their comparative advantages in the loan markets.
There is no need for the items traded in a swap to constitute interest payments. Swaps in the form of commodities, currency, debt, and total return are just a few of the more typical types of exotic swaps.
The Brent Crude oil spot price, for example, is swapped for a fixed price over a certain period of time as part of a commodities swap. Crude oil is the most prevalent commodity traded in commodity swaps, as seen above.
Exchanges of interest and principal payments on debt denominated in various currencies are called currency swaps. The principal is not a notional sum but is traded with interest obligations in the same transaction. Nations can exchange currencies. When China utilized swaps to assist Argentina in stabilizing its foreign currency reserves, for example, 2 When the euro began to plummet in value due to the Greek debt crisis in 2010, the US Federal Reserve engaged in an aggressive swap strategy with European central banks. 3
In the case of a publicly listed corporation, this would entail exchanging bonds for stocks as part of a debt-for-equity swap. Debt restructuring is a technique for firms to reorganize their capital structure or refinance their debts.
Total Return Swaps
Investment returns are traded for a fixed interest rate in a total return swap. Fixed-rate exposure to the underlying asset—a stock or an index—is given to the party paying the fixed-rate exposure. For example, the capital gain and dividend payments from an investment pool might be exchanged for an investor paying a set rate to a third party.
Credit Default Swap (CDS)
When a borrower fails on a loan, a credit default swap (CDS) protects the CDS buyer by transferring the lost principal and interest to the CDS seller. Unfortunately, the financial crisis of 2008 was exacerbated by excessive CDS market leverage and inadequate risk management.
Derivative contract in which cash flows or value of an asset are exchanged for another. This is called a “financial swap.” For example, if one firm pays a variable interest rate, another may offer a fixed interest rate to the first company in exchange for swapping interest payments. Swaps may also be used to trade other types of value or risk, such as the risk of a bond’s credit default.