Swap (Finance) - Explained
What is a Swap?
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Table of ContentsWhat is a Swap?How Does a Financial Swap Work?Types of SwapInterest rate swapCurrency swapCommodity SwapsDebt-equity swapTotal return swapsDebt-to-debt swapCredit default swapBenefits of credit default swapCases where swap can be usedHedging and Swaps
What is a Swap?
A swap refers to an exchange of a financial instrument between two parties. It is usually in the form of a derivative contract, and it takes place at a predetermined time as specified in the contract. Swap may be anything that ranges from cash flow, investment, liability, or payment for the other. However, in most cases, it involves cash flow which is usually based on the principal amount agreed upon by the concerned parties.
How Does a Financial Swap Work?
A derivative refers to contracts where two or more parties with a value based on an underlying financial asset are involved. It indicates a contract between two parties, where its value is determined by the price of the underlying assets. Parties engage in derivatives contracts so that they can be able to manage the risk that comes with buying or selling of assets with fluctuating prices. For a long time, international trade has depended on derivatives to deal with fluctuating exchange rates. However, the use of derivatives has extended to many other different types of transactions. The value of derivatives is derived from the performance of either of the following elements: interest rate, index, an asset, commodity, or currency. An important point to note about swaps is that they dont trade on exchanges. This also applies to the retail investor. Instead, swaps are contracts which happen over the counter mainly between businesses or financial institutions. There are different types of swaps, however, the most common one is the interest rate swap.
Types of Swap
Below are different types of swaps and how they work.
Interest rate swap
This is where two parties agree to exchange periodic interest payments. In other words, it is a means of exchanging future cash flows. Companies involved use it to exchange interest rate payments with each other. It is beneficial to both companies because as one company looks forward to receiving payment with a variable interest rate, the other one will instead want to limit future risks by receiving a fixed rate payment. Each party, therefore, looks forward to benefiting (a win-win situation). However, it can sometimes be a zero-sum game. In interest rate swap, two parties (for instance company A & B) decide to trade in a fixed-rate and variable-interest rate. Company A may have a bond that pays bank X the rate on offer, while company B holds a bond that offers a fixed payment of 5%. If bank X is expected to stay around 3%, then the contract has to clarify that the party paying the varying interest rate will have to pay bank X an addition of 2%. This way, both company A & B will look forward to receiving similar payments. The main investment is not traded, but the parties involved always agree on a base value to use to calculate the cash flows intended for exchange. In this case, one party gets to evade the risk associated with their security as it will offer a floating interest rate, while the other can take the advantage of the potential reward as he or she holds a more asset. Note that the interest rate is usually traded over the counter. Therefore, if you as a company decides to exchange interest, you and the company will have to agree on certain issues before you initiate a transaction. Length of the swap - There must be a mutual agreement between the two parties on the start date of the swap and the maturity date for the same. Terms of the swap - The terms laid down on the swap contract should be precise and clear to both parties.
In this type of swap, the parties exchange both principal and interest payment rate in one currency. It is a process through which buying and selling of currency are done simultaneously for the purpose of converting debt principal from the lenders currency to the debtors currency. The exchange of the principal is done at the market rates. The rates in the contract are usually the same for both the inception and maturity period. This means that the principal is exchanged along with the interest obligation. In most cases, the currency swap happens between countries. For instance, there exists a swap currency between China and Argentina that is helping them to stabilize their foreign reserves.
This refers to an exchange of a floating commodity price. The exchange of the commodity price usually has a set price, and it is done for a given period of time as agreed upon by the two parties. A good example of a commodity which is commonly used in this type of swap is crude oil meaning that oil companies often use this type of swap.
This is a type of swap where the exchange of debt for equity such as bonds for stocks is done. It happens more so in a publicly traded company. It is a means through which companies can finance their debt or relocate their capital structure. It can also be explained as an exchange of foreign debt usually to a third world country in exchange for a stake in the debtor country's national enterprise.
Total return swaps
In this type of swap, there is a total return when an asset is exchanged for a fixed interest rate. This enables the party paying the fixed rate to have contact with the underlying asset without having to pay the capital to hold it.
Debt to debt swap is where one exchanges the existing liability into a new loan. In this type of transaction, there is usually an extended period to pay back the loan.
Credit default swap
It refers to a financial contract where an investor is allowed to offset his or her credit risk with that of another investor. This happens when the lender fears that the borrower might default in paying back the amount lend. In this case, the lender uses the credit default swap to offset the risk. The credit default swap is usually acquired from another investor (like an insurance company) who agrees to pay back the lender in case the borrower fails to service the loan to maturity.
Benefits of credit default swap
- Credit default is instrumental in ensuring that various risks of an asset to be transferred to parties willing to bear them without the asset in question being involved in the trade.
- It prevents value fluctuations which may occur due to the changes in the credit quality of investments.
- It eliminates the preferred credit risk amount without creating new risks.
- Credit default swap can in exchange be a source of income for those institutions ready to accept the risk.
Cases where swap can be used
The following are instances when one may need to engage in any type of swap:
- When you have lots of a product that you feel, you need to get rid of in exchange for a good offer.
- When a board of directors agrees to a fair exchange of assets.
Hedging and Swaps
Hedging is a strategy used by investors in several types of swap to reduce risks in their investment. It aims at reducing the losses from unexpected market fluctuation. Because of the uncertainty in the foreign exchange markets, most investors resolve to hedge in order to protect their businesses from facing any form of risks. It simply transfers the unexpected risk to another party who is ready and willing to carry the loss.