What is a swap?

 

What is a swap?

A swap is a derivative contract through which two parties exchange the cash flows or liabilities of two different financial instruments. Most swaps involve cash flows based on notional principal amounts, such as loans or bonds, although the instrument can be almost anything. Usually, principals don’t change hands. Each cash flow constitutes a leg of the swap. One type of cash flow is usually fixed, while the other is variable, based on benchmark interest rates, floating currency exchange rates or index prices.

The most common swaps are interest rate swaps. Swaps are not traded on exchanges, and retail investors generally do not participate in swaps. Conversely, swaps are over-the-counter (OTC) contracts between businesses or financial institutions that are primarily tailored to the needs of both parties.

 

Swap Explained

interest rate swap

In an interest rate swap, two parties to a transaction exchange cash flows based on a notional principal amount (which is not actually exchanged) to hedge interest rate risk or speculate. For example, suppose that Company ABC has just issued a $1 million five-year bond with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Additionally, ABC management is concerned about rising rates, assuming a LIBOR of 2.5%.

The management team finds another company, XYZ Inc., which is willing to pay ABC LIBOR plus 1.3% APR over 5 years on a notional principal of $1 million. In other words, XYZ will fund ABC’s interest payments on its latest bond offering. In exchange, ABC pays XYZ a fixed annual interest rate of 5% on a notional value of $1 million for five years. ABC stands to benefit from the swap if interest rates rise significantly over the next five years. XYZ will benefit if interest rates fall, stay flat, or only rise gradually.

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According to the Fed’s announcement, banks should stop using LIBOR to write contracts by the end of 2021. Intercontinental Exchange, the agency responsible for LIBOR, will stop issuing LIBOR one week and two months after December 31, 2021. All LIBOR contracts must be completed by June 30, 2023.

Here are two scenarios for this interest rate swap: LIBOR rising 0.75% per year and LIBOR rising 0.25% per year.

plan 1

If LIBOR rises 0.75% per year, the total interest paid by ABC to its bondholders over a five-year period is $225,000. Let’s break down the calculation:

Libor + 1.30% Variable interest paid by XYZ to ABC 5% interest paid by ABC to XYZ ABC’s earnings Loss of XYZ
the first year 3.80% $38,000 $50,000 -$12,000 $12,000
Year 2 4.55% $45,500 $50,000 -$4,500 $4,500
Year 3 5.30% $53,000 $50,000 $3,000 -$3,000
Year 4 6.05% $60,500 $50,000 $10,500 -$10,500
Year 5 6.80% $68,000 $50,000 $18,000 -$18,000
all $15,000 ($15,000)

In this case, ABC is doing well because its interest rate is fixed at 5% through swaps. ABC pays $15,000 less than variable rates. XYZ’s forecast was incorrect and the company lost $15,000 through swaps because interest rates were rising faster than expected.

Scenario 2

In the second case, LIBOR rises by 0.25% per year:

Libor + 1.30% Variable interest paid by XYZ to ABC 5% interest paid by ABC to XYZ ABC’s earnings Loss of XYZ
the first year 3.80% $38,000 $50,000 ($12,000) $12,000
Year 2 4.05% $40,500 $50,000 ($9,500) $9,500
Year 3 4.30% $43,000 $50,000 ($7,000) $7,000
Year 4 4.55% $45,500 $50,000 ($4,500) $4,500
Year 5 4.80% $48,000 $50,000 ($2,000) $2,000
all ($35,000) $35,000
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In this case, since interest rates are slowly rising, ABC is better off not engaging in swaps. XYZ made a profit of $35,000 by participating in the swap because its prediction was correct.

This example does not consider other benefits that ABC may gain by participating in the exchange. For example, maybe the company needs another loan, but the lender is reluctant to do so unless the interest obligations on its other bonds are fixed.

In most cases, both parties will act through a bank or other intermediary to take a share of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on their comparative advantage in the fixed-rate or floating-rate loan market.

 

other swaps

The instrument of a swap transaction does not have to be an interest payment. There are countless exotic swap agreements, 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 oil spot price, for a fixed price over an agreed-upon period. As this example shows, commodity swaps most often involve crude oil.

currency swap

In a currency swap, parties exchange interest and principal for debt denominated in different currencies. Unlike interest rate swaps, the principal is not a nominal amount, but is exchanged with an interest obligation. Currency swaps can take place between countries. For example, China has used a swap with Argentina to help stabilize its foreign exchange reserves.During the European financial crisis in 2010, the Federal Reserve and the European Central Bank adopted an aggressive swap strategy to stabilize the euro, which was devalued by the Greek debt crisis.

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debt-to-equity swap

Debt-to-equity swap involves debt-to-equity swapIn the case of public companies, that would mean bonds for stocks. This is a way for companies to refinance their debt or reallocate their capital structure.

total return swap

In a total return swap, the total return of an asset is exchanged for a fixed interest rate.This leaves the party paying the fixed rate risk of the underlying assetstock or index. For example, an investor can pay a fixed interest rate to one party in exchange for capital appreciation and dividend payments from the stock pool.

Credit Default Swap (CDS)

A credit default swap (CDS) is an agreement between one party to pay the CDS buyer the principal and interest on loan losses if the borrower defaults on the loan. Excessive leverage and poor risk management in the CDS market contributed to the 2008 financial crisis.

 

Swap Summary

A financial swap is a derivative contract in which one party exchanges or “exchanges” the cash flow or the value of one asset for another. For example, a company paying a variable rate could exchange its interest payments with another company, which would pay the first company a fixed rate. Swaps can also be used to exchange other types of value or risk, such as the possibility of a bond’s credit default.

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