Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specified period of time. Swaps offer great flexibility to design and structure contracts based on mutual agreement. This flexibility generates many exchange variations, each of which has a specific purpose.
There are several reasons why the parties agree to such an exchange:
- Investment objectives or repayment scenarios may have changed.
- There may be a greater financial benefit to switching to available alternative or new cash flows.
- The need may arise to cover or mitigate the risk associated with repaying a variable rate loan.
Interest rate swaps
The most popular types of swaps are simple interest rate swaps. They allow two parties to exchange fixed and floating cash flows on an interest-bearing investment or loan.
Businesses or individuals are trying to obtain profitable loans, but their selected markets may not offer the preferred lending solutions. For example, an investor may get a cheaper loan in a floating rate market, but prefers a fixed rate. Interest rate swaps allow the investor to change cash flows as desired.
Suppose Paul prefers a fixed-rate loan and has loans available at a floating rate (LIBOR + 0.5%) or at a fixed rate (10.75%). Mary prefers a floating rate loan and has floating rate (LIBOR + 0.25%) or fixed rate (10%) loans available. Due to a better credit rating, Mary has an advantage over Paul in both the floating rate market (0.25%) and the fixed rate market (0.75%). He
Your advantage is greater in the fixed rate market, so you take the fixed rate loan. However, since you prefer the floating rate, you enter into a swap agreement with a bank to pay LIBOR and receive a fixed rate of 10%.
Paul borrows at a floating rate (LIBOR + 0.5%), but since he prefers fixed, he signs a swap contract with the bank to pay fixed 10.10% and receive the floating rate.
Profits: Paul pays (LIBOR + 0.5%) to the lender and 10.10% to the bank, and receives LIBOR from the bank. Your net pay is 10.6% (fixed). The swap effectively converted your original floating payment to a fixed rate, allowing you to obtain the cheapest rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. Your net pay is LIBOR (floating). The swap effectively converted your original fixed payment to the desired float, allowing you to obtain the cheapest rate. The bank takes a 0.10% haircut from what it receives from Paul and pays Mary.
The transactional value of capital that changes hands in currency markets exceeds that of all other markets. Currency swaps offer efficient ways to hedge currency risk.
Suppose an Australian company is setting up a company in the UK and needs GBP 10 million. Assuming the AUD / GBP exchange rate is 0.5, the total amounts to AUD 20 million. Similarly, a UK-based company wants to set up a plant in Australia and needs AUD 20 million. The cost of a loan in the UK is 10% for foreigners and 6% for locals, while in Australia it is 9% for foreigners and 5% for locals. Apart from the high cost of the loan for foreign companies, it can be difficult to obtain the loan easily due to procedural difficulties. Both companies have a competitive advantage in their domestic loan markets. The Australian firm can take a low-cost loan of AUD 20 million in Australia, while the English firm can take a low-cost loan of GBP 10 million in the UK. Suppose both loans require six-month payments.
Then both companies enter into a currency exchange agreement. Initially, the Australian firm gives A $ 20 million to the English firm and receives £ 10 million, allowing both firms to start business in their respective foreign countries. Every six months, the Australian company pays the English company the interest payment on the English loan = (notional amount in pounds sterling * interest rate * period) = (10 million * 6% * 0.5) = 300,000 pounds sterling while the English company pays the Australian company the interest payment on the Australian loan = (notional amount in AUD * interest rate * period) = (20 million * 5% * 0.5) = AUD 500,000. Interest payments continue until the end of the swap contract, at which point the original notional currency amounts will be exchanged with each other.
ProfitsBy participating in a swap, both companies were able to obtain low-cost loans and protect themselves against fluctuations in interest rates. There are also variations in currency swaps, which include fixed vs. float and float vs. float. In short, the parties can hedge against exchange rate volatility, secure better loan rates, and receive foreign capital.
Commodity exchanges are common between people or companies that use raw materials to produce goods or finished products. Profits from a finished product can be affected if raw material prices change, since producer prices may not change in sync with raw material prices. A commodity swap allows the receipt of payments tied to the price of commodities against a fixed rate.
Suppose two parties enter into a commodity exchange for more than one million barrels of crude oil. One of the parties agrees to make semi-annual payments at a fixed price of $ 60 per barrel and to receive the current (floating) price. The other party will receive the fixed rate and pay the variable.
If crude oil rises to $ 62 at the end of six months, the first party will be responsible for paying the fixed ($ 60 * 1 million) = $ 60 million and receiving the variable ($ 62 * 1 million) = $ 62 million of the second part. The net cash flow in this scenario will be $ 2 million transferred from the second party to the first. Alternatively, if crude oil falls to $ 57 in the next six months, the first party will pay $ 3 million to the second party.
Profits: The first part has fixed the price of the raw material through the use of a currency swap, achieving a price hedge. Commodity swaps are effective hedging tools against changes in commodity prices or changes in spreads between the final product and the prices of raw materials.
Credit default swaps
The credit default swap provides insurance in the event of default by a third party borrower. Suppose Peter purchased a 15-year bond issued by ABC, Inc. The bond has a value of $ 1,000 and pays annual interest of $ 50 (that is, a 5% coupon rate). Peter is concerned that ABC, Inc. may default, so he enters into a credit default swap agreement with Paul. Under the swap agreement, Peter (CDS buyer) agrees to pay $ 15 per year to Paul (CDS seller). Paul trusts ABC, Inc. and is willing to assume the risk of default on his behalf. For the receipt of $ 15 per year, Paul will offer Peter insurance on his investment and returns. If ABC, Inc. defaults, Paul will pay Peter $ 1,000 plus the remaining interest payments. If ABC, Inc. does not default during the 15-year duration of the bond, Paul benefits by keeping the $ 15 per year without paying Peter.
Profits: The CDS works as insurance to protect lenders and bondholders from the risk of default by borrowers.
Zero coupon swaps
Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties in the swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are not paid periodically, but only once at the end of the swap contract maturity. The other party paying the floating rate continues to make periodic and regular payments following the standard swap payment schedule.
A fixed-fixed zero coupon swap is also available, in which one party does not make any interim payments, but the other party continues to pay fixed payments on schedule.
Profits: The zero coupon swap (ZCS) is used primarily by companies to hedge a loan in which interest is paid at maturity or by banks that issue bonds with interest payments at the end of maturity.
Total return swaps
A total return swap gives the investor the benefits of owning securities, without real property. A TRS is a contract between a full refund payer and a full refund receiver. The payer generally pays the full refund of the agreed guarantee to the recipient and receives a fixed / variable rate payment in return. The agreed (or referenced) security can be a bond, index, equity, loan, or commodity. Total return will include all income generated and capital appreciation.
Suppose that Paul (the payer) and Mary (the receiver) enter into a TRS agreement on a bond issued by ABC Inc. If the price of ABC Inc.’s shares increases (capital appreciation) and pays a dividend (income generation ) for the duration of the swap Paul will pay Mary those benefits. In return, Mary has to pay Paul a predetermined fixed / floating rate for the duration.
Profits: Mary receives a total rate of return (in absolute terms) without owning the security and has the advantage of leverage. She represents a hedge fund or bank that benefits from leverage and additional income without owning the security. Paul transfers credit risk and market risk to Mary, in exchange for a fixed / floating payment stream. Represents a trader whose long positions can be converted to a short hedging position and, at the same time, defer the gain or loss until the end of the swap maturity.
The bottom line
Exchange contracts can be easily customized to meet the needs of all parties. They offer mutually beneficial arrangements for participants, including intermediaries such as banks that facilitate transactions. Even so, participants should be aware of the potential obstacles because these contracts are executed without a prescription and without regulations.