What is Swap?

Exchanging things is called Swap. It can be anything you may be swapping your pen, mobile etc., with your friends. Swap has evolved from Barter system. In finance, a swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. 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. The cash flows are calculated over a notional principal amount. Consequently, swaps can be in cash or collateral. Swaps can be used to hedgecertain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

History of Swap:
In ancient medieval period there was no currency or money. So people use to exchange things i.e. Farmer exchanging Rice with Cobbler for Shoes, this was called as Barter System.

Swaps were first introduced to the public in 1981 when IBMand the World Bank entered into a swap agreement.

Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more than $347 trillion in 2010, according to Bank for International Settlements (BIS). 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, Intercontinental Exchange and Frankfurt-based Eurx AG. The Bank for International Settlements (BIS) publishes statistics on the notional amountsoutstanding 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:

Define SWAP:
A Swap is an agreement between two parties to Exchange Cash Flows based on underlying asset. Such as, Demand & Supply Two Counterparties Mutual Agreement Rate of Interest Notional Amount Trade Date/Effective Date Settlement Date/Payment Date/ Maturity. Reaffix date Accrual Date & End of Accrual Date Coupon Interest

FEES FOR SWAP:

Brokerage / Consultancy Fee Loading Fee / Entry Fee Admin Fee Assignment Fee Exit Fee/Termination Fee

Benefits and Drawbacks

Benefits Customizable due to over-the-counter nature of the product No regulatory issues Low cost

 Disadvantages Significant cash flows can result in distress sale Termination date and rolling over cost Cost due to customization Credit Risk

Types of Swaps:

Interest rate swaps:

An interest rate swap (IRS) is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate from one floating rate to another. Interest rate swaps are commonly used for both hedging and speculating.

Advantages of Interest Rate Swap:

There are many advantages of interest rates swaps like below, Swapping from fixed to floating may save issuer money. Protects against adverse movements in interest rates. No premium is paid to enter into a swap. No principal amount is exchanged.

Cross currency swaps:

Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

For example:
USD being exchanged with GBP AUD being exchanged with USD

Circus swaps:
One of the most common forms of FOREX transactions, the circus swap is a specialized type of currency coupon swap wherein one party trades a fixed-rate loan in one currency to the second party for a comparable floating rate loan in a different currency.

For example Callable &Putable Swap.

Callable Swap

An exchange of cash flows in which one counterparty makes payments based on a fixed interest rate, the other counterparty makes payments based on a floating interest rate and the counterparty paying the fixed interest rate has the right to end the swap before it matures. Putable Swap

An exchange of cash flows in which one counterparty makes payments based on a fixed interest rate, the other counterparty makes payments based on a floating interest rate, and the counterparty paying the floating interest rate (and receiving the fix rate) has the right to end the swap before it matures.

Credit default swaps:

A credit default swap is an agreement by one party to accept a premium at regular intervals in return for making a larger payment if a specific company defaults, goes bankrupt, or suffers a negative credit event. It is an agreement between a protection buyer and a protection seller

whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity.

CDS- An Example:
A pension fund owns 10 Mn Euros worth of a 5 year bond issued by X Corp. To manage the risk, they buy a CDS from Derivative Bank on a nominal of 10 million Euros which trades at 200 basis points. The pension fund pays a premium of 2% of 10 million (200,000 Euros per annum) as quarterly payments Derivative Bank. In case of no default PF receives 10 Mn Euros on completion of quarterly payments for 5 years. If X Corp. defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of 10 million Euros.

Types of Credit Events:

Bankruptcy by the Reference Credit Restructuring Failure to pay a pre-agreed asset or assets ("Reference Obligation")

Settlement of CDS:
Cash Settlement - Reference obligation minus its post-default trading value as determined by a pre-agreed dealer poll mechanism. Physical Delivery - Transfer of a pre-agreed asset or assets ("Deliverable Obligation") to the seller in exchange for a payment equal to the notional of the contract.

Equity swaps:
An Equity Swap is a contractual agreement between two counterparties to exchange cash flows arising from specific assets over a defined period. The cash flows are exchanged periodically (i.e. monthly, quarterly) and are based upon the fixed-dollar or notional value of the swap.

The return is calculated based on a pre-determined notional principal and may or may not include dividends. The payments occur on regularly scheduled dates over a specified period of time. Equity swaps are offered by derivatives dealers in much the same manner as their offerings of interest rate, currency, and commodity swaps. Dealers typically charge a bid-ask spread and hedge any risk they have assumed by transacting in the underlying stock or index or another derivative on the stock or index.

Type of Equity SWAPS

There are three main types of equity swaps: An Equity Swap with the Equity Return paid against a Fixed Rate. An Equity Swap with the Equity Return paid against a Floating Rate. An Equity Swap with the Equity Return paid against another Equity Return.

Commodity swaps:
A swap where exchanged cash flows are dependent on the price of an underlying commodity. This is usually used to hedge against the price of a commodity.

Types of commodity swaps:

Fixed-floating:

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices. Commodity-for-interest:

Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate.

Example:

A large US refinery wants to launch a program that would allow the customers to lock in the price they pay the Refinery for a pre-specified quantity of oil products during the coming year. To protect itself from financial loss arising out of market fluctuation, the refinery enters into a one-year Fixed for Floating Swap with Sempra Energy Trading Corp. ("SET") to hedge 100,000 barrels of fuel oil per month at a fixed price of $22.00/bbl. Under the swap agreement, the Refinery makes a monthly fixed payment to SET equal to $22.00/barrel. SET, in exchange, makes a floating payment to the Refinery based on the arithmetic average of the daily settlement prices of the prompt NYMEX crude oil futures contract for each of the Pricing Periods for which the Reference Price is quoted.

Equity default swaps:

Equity default swap is a vehicle for one party to provide another protection against some possible event relating to some companys stock. The event being protected against is called the trigger event or knock-in event. For example, the equity default swap might provide protection against a 70% decline in the stock price from its value when the equity default swap was initiated.

Advantages of Equity Default Swap:

Trigger events are easier to define since there is less ambiguity over the stock price movement. Recovery rates are fixed for equity default swaps. Equity default swaps can be structured with various trigger levels loosely corresponding to various degrees of corporate impairment.

Swapation:
A Swapation is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "Swapation" typically refers to options on interest rate swaps. A Swapation is a financial instrument granting the
owner an option to enter swap agreement.

To specify a Swapation, there must be three basic parameters:

The expiration date of the option. The fixed rate on the underlying swap. The tenor (time to maturity at exercise of the option) of the swap.

There are two types of settlement possible for a Swapation contract.

Physical settlement, in which case an option is actually entered into upon exercise. Cash settlement, in which case the market value of the underlying swap changes hands upon exercise.

Functioning of a Swapation:
The purchaser of the Swapation pays an upfront premium. The fixed rate specified for the Swapation plays a role very similar to that of a strike price. The holder of the Swapation will decide whether or not to exercise based on whether swap rates rise above or fall below that fixed rate. For this reason, the fixed rate is often called the strike rate. If the Swapation is exercised, there is no strike price to pay. The two parties simply put on the prescribe swap.

Purpose of Swapation:
The primary purposes for entering into a Swapation are: To hedge call or put positions in bond issues. To change the tenor of an underlying swap. To assist in the engineering of structured notes. To change the payoff profile of the firm.

Types of Swapation
American Swapation, in which the owner is allowed to enter the swap on any day that falls within a range of two dates.

Bermudan Swapation, in which the owner is allowed to enter the swap on a sequence of dates. European Swapation, in which the owner is allowed to enter the swap on one specified date.

INTEREST RATE SWAPS.

The interest rate swap allows a company to borrow capital at fixed (or floating rate ) and exchange its interest payments with interest payments at floating rate (or fixed rate ).

Suppose company x is AAA-rated company located in USA. The company has borrowed $10 million floating-rate loan to finance a capital expenditure investment. The five year floating rate loan is indexed to LIBOR. LIBOR is the market-determined interest rate for banks to borrow from each other in the Eurodollar market.

When company issued floating-rate loan the interest rate were low. Now the interest rates are showing great volatility. Under the floating-rate loan the companys interest payments will depend on LIBOR rate. The interest amount each year will be: LIBOR RATE X $10 million. Suppose LIBOR rate is either 5.75% , 6.25% or 6.75%. The companys floating-rate interest payments will be:

Suppose company x expected to have a steady flow of revenue from its investment. The company, instead of a floating-rate loan, could have taken five-year fixed-rate loan to finance the capital expenditure. The fixed-rate loan would have made sense for company x since it would be using a fixed-rate liability (loan) to finance a fixed-rate asset (capital expenditure). Under its floating-rate loan, the company will have to pay higher amount of interest when the interest rate rises while it is earning a steady profit from its investment. With the fixed-rate loan, the company would pay constant amount of interest and could avoid the interest rate risk associated with a floating-rate loan.

What should company x do?

The company could buy back the floating-rate loan and instead take fixed-rate loan. This is a costly alternative. The company has to incur transaction cost ad might suffer trading loss.

However , there is a convenient alternative available to the company. It can enter into an interest rate swap. The company can swap the fixed-rate loan for the floating-rate loan. It would pay fixed payments for payments indexed to floating interest rate. If the interests rise, it will increase the companys interest amount on the floating-rate loan but, under swap, its receipts will also increase. Thus, swap will offset the companys exposure. Company x finds that currently the floating-rate based on LIBOR can be exchanged for 6.25% fixed-rate loan. If the company decides to enter into a swap arrangement, it can agree to pay 6.25% on national amount of $10 million to a swap dealer and receive payment for the LIBOR rate on the same amount of the notional capital.

The net cash flow consequences of swap agreement and the floating-rate loan for the company under the three different LIBOR rates will be shown bellow:

You may note that company xs total payment on the floating-rate loan with swap is equal to $6,25,000 irrespective of what happens to LIBOR rate. The company has been able to hedge its interest rate risk without buying back its floating-rate loan and issuing fixed-rate loan. Through the swap arrangement, the company converted the floating-rate loan into 6.25% synthetic fixed-rate loan. The interest rate swaps can be used by portfolio managers and pension fund managers to convert their bond or money market portfolio from floating rate (or fixed rate) to synthetic fixed rate (or synthetic floating rate). There are many other possible applications of the interest rate swaps.