INTRODUCTION

A swap is a derivative in which two counter parties 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 (coupon) payments associated
with such bonds. Specifically, 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 accrued and
calculated. Usually at the time when the contract is initiated, at least one of these series of cash
flows is determined by an uncertain variable such as a floating interest rate, foreign exchange
rate, equity price, or commodity price.
The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or
an option, the notional amount is usually not exchanged between counterparties. Consequently,
swaps can be 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.
Swaps were first introduced to the public in 1981 when IBM and 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 $348
trillion in 2010, according to Bank for International Settlements (BIS)

Swap market

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, the
largest U.S. futures market, the Chicago Board Options Exchange, Intercontinental Exchange
and Frankfurt-based Eurex AG.
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:

The CDS and currency swap markets are dwarfed by the interest rate swap market. All three
markets

peaked

in

mid-2008.

Source: BIS Semiannual OTC derivatives statistics at end-December 2008

Notional outstanding (in USD trillion)

Currency

End

End

End

End

End

End

End

2000

2001

2002

2003

2004

2005

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

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

Pound
sterling

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1], "OTC
Derivatives Market Activity in the Second Half of 2006", BIS,
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
but this rate is known to be rigged (Barclays and others banks have been convicted in
the 2010-2012 LIBOR scandal).
Types of swaps
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. There are also
many other types of swaps.
Interest rate swaps[edit]
Main article: Interest rate swap

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but
wants to pay floating. By entering into an interest rate swap, the net result is that each
party can 'swap' their existing obligation for their desired obligation. Normally, the
parties do not swap payments directly, but rather each sets up a separate swap with a
financial intermediary such as a bank. In return for matching the two parties together, the
bank takes a spread from the swap payments.

The most common type of swap is an interest rate swap. 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.
For example, party B makes periodic interest payments to party A based on
a variable interest rate of LIBOR +70 basis points. Party A in return makes
periodic interest payments based on a fixed rate of 8.65%. 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. In reality, the actual rate received by A
and B is slightly lower due to a bank taking a spread.
Currency swaps[edit]
Main article: Currency swap
A 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 are also motivated bycomparative
advantage. Currency swaps entail swapping both principal and interest between the parties,
with the cashflows in one direction being in a different currency than those in the opposite
direction. It is also a very crucial uniform pattern in individuals and customers.
Commodity swaps[edit]
Main article: Commodity swap
A commodity swap is an agreement whereby a floating (or market or spot) price is
exchanged for a fixed price over a specified period. The vast majority of commodity swaps
involve crude oil.
Subordinated risk swaps[edit]
A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or
equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain
risks. These can include any form of equity, management or legal risk of the underlying (for
example a company). Through execution the equity holder can (for example) transfer shares,
management responsibilities or else. Thus, general and special entrepreneurial risks can be
managed, assigned or prematurely hedged. Those instruments are traded over-thecounter (OTC) and there are only a few specialized investors worldwide.
Other variations[edit]
There are myriad different variations on the vanilla swap structure, which are limited only by
the imagination of financial engineers and the desire of corporate treasurers and fund
managers for exotic structures.[1]

 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.
An option on a swap is called a swaption. These provide one party with the right but not
the obligation at a future time to enter into a swap.
A variance swap is an over-the-counter instrument that allows one to speculate on or
hedge risks associated with the magnitude of movement, a CMS, is a swap that allows
the purchaser to fix theduration of received flows on a swap.
An Amortising swap is usually an interest rate swap in which the notional principal for
the interest payments declines during the life of the swap, perhaps at a rate tied to the
prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is
suitable to those customers of banks who want to manage the interest rate risk involved
in predicted funding requirement, or investment programs.
A Zero coupon swap is of use to those entities which have their liabilities denominated
in floating rates but at the same time would like to conserve cash for operational
purposes.
A Deferred rate swap is particularly attractive to those users of funds that need funds
immediately but do not consider the current rates of interest very attractive and feel that
the rates may fall in future.
An Accrediting swap is used by banks which have agreed to lend increasing sums over
time to its customers so that they may fund projects.

 A Forward swap is an agreement created through the synthesis of two swaps differing in
duration for the purpose of fulfilling the specific time-frame needs of an investor. Also
referred to as a forward start swap, delayed start swap, and a deferred start swap.
Valuation[edit]
Further information: Rational pricing Swaps and Arbitrage
The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap
is worth zero when it is first initiated, however after this time its value may become positive
or negative.[1]There are two ways to value swaps: in terms of bond prices, or as a portfolio
of forward contracts.[1]
Using bond prices[edit]
While principal payments are not exchanged in an interest rate swap, assuming that these are
received and paid at the end of the swap does not change its value. Thus, from the point of
view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate
bond (i.e. receiving fixed interest payments), and a short position in a floating rate
note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the
opposite positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash
flows correspond to those in the swap. Thus, the home currency value is:
, where
swap,

is the domestic cash flows of the

is the foreign cash flows of the 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.
Arbitrage arguments[edit]
As mentioned, to be arbitrage free, the terms of a swap contract are such that,
initially, the NPV of these future cash flows is equal to zero. Where this is not
the case, arbitrage would be possible.
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:
assume the position with the lower present value of payments, and borrow funds equal to this
present value
meet the cash flow obligations on the position by using the borrowed funds, and receive the
corresponding payments - which have a higher present value
use the received payments to repay the debt on the borrowed funds
pocket the difference - where the difference between the present value of the loan and the
present value of the inflows is the arbitrage profit.
Subsequently, once traded, the price of the Swap must equate to the price of the
various corresponding instruments as mentioned above. Where this is not true, an
arbitrageur could similarly short sellthe overpriced instrument, and use the
proceeds to purchase the correctly priced instrument, pocket the difference, and
then use payments generated to service the instrument which he is short.
External links[edit]

Understanding Derivatives: Markets and Infrastructure Federal Reserve

Bank of Chicago, Financial Markets Group

swaps-rates.com, interest swap rates statistics online

Bank for International Settlements

International Swaps and Derivatives Association

First take, Dodd-Frank's SECs Cross-Border Derivatives Rule

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Investopedia
What is a 'Swap'
A swap is a derivative contract through which two parties exchange financial instruments. These
instruments can be almost anything, but most swaps involve cash flows based on a notional
principal amount that both parties agree to. Usually, the principal does not change hands. Each
cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is
variable, that is, based on a a benchmark interest rate, floating currency exchange rate or index
price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges,
and retail investors do not generally engage in swaps. Rather, swaps are over-thecounter contracts between businesses or financial institutions.
Next Up
1.

Credit Default Swap - CDS

2.

Non-Deliverable Swap - NDS

3.

Catastrophe Swap
4.

Bond Swap

5.
BREAKING DOWN 'Swap'
Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount
(this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate.
For example, say ABC Co. has just issued $1 million in five-year bonds with a variable annual
interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130basis
points). LIBOR is at 1.7%, low for its historical range, so ABC management is anxious about an
interest rate rise.
They find another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR plus
1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund ABC's
interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 6%
on a notional value of $1 million for five years. ABC benefits from the swap if rates rise
significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.
Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year, and 2)
LIBOR rises 2% per year.
Scenario 1
If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bond holders
over the five-year period are $225,000:
225000=1000000*(5*0.013+0.017+0.0245+0.032+0.0395+0.047)

in other words, $75,000 more than the $150,000 ABC would have paid if LIBOR had remained
flat:
150000=1000000*5*(0.013+0.017)
ABC pays XYZ $300,000:
300000=1000000*5*0.06
and receives $225,000 in return (the same as ABC's interest payments to bond holders). ABC's
net loss on the swap comes to $75,000.

Scenario 2
In the second scenario, LIBOR rises by 2% a year. This brings ABC's total interest payments to
bond holders to $350,000
350000=1000000*(0.013*5+0.017+0.037+0.057+0.077+0.097)

XYZ pays this amount to ABC, and ABC pays XYZ $300,000 in return. ABC's net gain on the
swap is $50,000.

Note than in most cases the two parties would act through a bank or other intermediary, which
would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest
rate swap depends on their comparative advantage in fixed or floating rate lending markets.
Other Swaps
The instruments exchanged in a swap do not have to be interest payments. Countless varieties of
exotic swap agreements exist, but relatively common arrangements include commodity swaps,
currency swaps, debt swaps and total return swaps.
Commodity swaps
Commodity swaps involve the exchange of a floating commodity price, such as the Brent
Crude spot price, for a set price over an agreed-upon period. As this example suggests,
commodity swaps most commonly involve crude oil.
Currency swaps

In a currency swap, the parties exchange interest and principal payments on debt denominated in
different currencies. Unlike in an interest rate swap, the principal is not a notional amount, but is
exchanged along with interest obligations. Currency swaps can take place between countries:
China has entered into a swap with Argentina, helping the latter stabilize its foreign reserves, and
a number of other countries.
Debt-equity swaps
A debt-equity swap involves the exchange of debt for equity; in the case of a publicly traded
company, this would mean bonds for stocks. It is a way for companies to refinance their debt.
Total return swaps
In a total return swap, the total return from an asset is exchanged for a fixed interest rate. This
gives the party paying the fixed rate exposure to the underlying asseta stock or an index for
examplewithout having to expend the capital to hold it.

Who Would Use a Swap?

The motivations for using swap contracts fall into two basic categories: commercial needs
and comparative advantage. The normal business operations of some firms lead to certain types
of interest rate or currency exposures that swaps can alleviate. For example, consider a bank,
which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest
on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous
difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to
convert its fixed-rate assets into floating-rate assets, which would match up well with its
floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types of financing. However,
this comparative advantage may not be for the type of financing desired. In this case, the
company may acquire the financing for which it has a comparative advantage, then use a swap to
convert it to the desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations into Europe,
where it is less known. It will likely receive more favorable financing terms in the U.S. By then
using a currency swap, the firm ends with the euros it needs to fund its expansion.
Exiting

Swap

Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination
date. This is similar to an investor selling an exchange-traded futures or option contract before
expiration. There are four basic ways to do this:
1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable
market value, so one party may terminate the contract by paying the other this market value.
However, this is not an automatic feature, so either it must be specified in the swaps contract in
advance, or the party who wants out must secure the counterparty's consent.
2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example
above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the
contract to a third party. As with Strategy 1, this requires the permission of the counterparty.
4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a
party to set up, but not enter into, a potentially offsetting swap at the time they execute the
original swap. This would reduce some of the market risks associated with Strategy 2.

history

A:

Swap agreements originated from agreements created in Great Britain in the 1970s to circumvent
foreign exchange controls adopted by the British government. The first swaps were variations on
currency swaps. The British government had a policy of taxing foreign exchange transactions
that involved the British pound. This made it more difficult for capital to leave the country,
thereby increasing domestic investment.

Swaps were originally conceived as back-to-back loans. Two companies located in different
countries would mutually swap loans in the currency of their respective countries. This
arrangement allowed each company to have access to the foreign exchange of the other country
and avoid paying any foreign currency taxes.
IBM and the World Bank entered into the first formalized swap agreement in 1981. The World
Bank needed to borrow German marks and Swiss francs to finance its operations, but the
governments of those countries prohibited it from borrowing activities. IBM, on the other hand,
had already borrowed large amounts of those currencies, but needed U.S. dollars when interest
rates were high for corporate borrowers. Salomon Brothers came up with the idea for the two
parties to swap their debts. IBM swapped its borrowed francs and marks for the World Banks
dollars. IBM further managed its currency exposure with the mark and franc. This swaps market
has since grown exponentially to trillions of dollars a year in size.
The history of swaps wrote another chapter during the 2008 financial crisis when credit default
swaps on mortgage backed securities (MBS) were cited as one of the contributing factors to the
massive economic downturn. Credit default swaps were supposed to provide protection for the
non-payment of mortgages, but when the market started to crumble, parties to those agreements
defaulted and were unable to make payments. This has led to substantial financial reforms of
how swaps are traded and how information on swap trading is disseminated. Swaps were
historically traded over the counter, but they are now moving to trading on centralized
exchanges.