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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.
Interest rate swaps

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 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.

For example, party B makes periodic interest payments to party A based on a variable interest
rate of LIBOR +70basis 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.

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 also are motivated by comparative advantage.
Currency swaps ( These entail swapping both principal and interest b/w the parties, with the
cashflows in one direction being in a different currency than those in the opposite direction.
Commodity swaps
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.
Equity Swap
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.
Credit default swaps
credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of
payments to the seller and, in exchange, receives a payoff if a credit instrument - typically
a bond orloan - goes into default (fails to pay). Less commonly, the credit event that triggers the
payoff can be a company undergoing restructuring, bankruptcy or even just having its credit
rating downgraded. CDS contracts have been compared with insurance, because the buyer pays
a premium and, in return, receives a sum of money if one of the events specified in the contract
occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and
may also cover an asset to which the buyer has no direct exposure.

Goal programming
Goal programming is a branch of multiobjective optimization, which in turn is a branch
of multi-criteria decision analysis (MCDA), also known as multiple-criteria decision making
(MCDM). This is an optimization programme. It can be thought of as an extension or
generalization of linear programming to handle multiple, normally conflicting objective
measures. Each of these measures is given a goal or target value to be achieved. Unwanted
deviations from this set of target values are then minimised in an achievement function. This can
be a vector or a weighted sum dependent on the goal programming variant used. As satisfaction
of the target is deemed to satisfy the decision maker(s), an underlying satisficing philosophy is
assumed.