A swap is an agreement between two parties to exchange cash flows in the future.
It defines how the cash flows are caculated and when they are paid.
Over The Counter
All Swaps are traded Over The Counter
The cash flows that are swapped on the payment dates are often referred to as coupons
Different Types of Swap
Fixed for Floating Currency - Also known as Plain Vanilla
Fixed for Fixed Currency -
Swap with one payment equivalent to a Forward
The following can be thought of as equivalent
Agree to buy 50 barrels of oil at £1 a barrel in one year from now and assume that as soon as we buy the oil we sell it immediately.
Equivalent to a swap that agrees to pay £50 and receive (50 * P), where P is the market proce of 1 barrel of oil in one year from now.
Credit Default Swaps
Cross Currency Swaps
Foreign Exchange Swaps
Interest Rate Swaps
Total Return Swaps
Swaps - for those borrowing money are liability swaps
for those investing they are assets Swaps
Swaps are essentially just a series of FRAs. A swap starting at a future date is a forward swap.
Characteristics of a swap
The fixed Rate
The variable Rate
- the settlement periods (6 months)
The total maturity
The underlying notional principal
For example, the parties may agree that one pays 5.5% and the other pays Eurodollar LIBOR on a notional underlying principal of $50m. The swap is to last 5 years and the settlement periods are 6 monthly.
That means every 6 months 5.5% is compared with Eurodollar LIBOR and the net sum of money is exchanged.
If the difference was 1% then 1% of $50m for 6 motnhs is the sum to be exchanged: -$250,000
The money however is not paid over until the end of the 6 month period (not at the beginning)
This is because interest payments are paid in arrears. A bank for example sets the rate on an actual loan for 6 months at 5.5% but the interest is paid at the end.
If the bank is at risk to a "fall in interest rates" (because it has lent floating and borrowed fixed)
then it will buy fixed interest rate securities, whose price will rise when interest rates fall.
If the bank is at risk to a "rise in interest rates" (because it has borrowed floating and lent fixed), t hen it can hedge in the futures market by selling an interest rate future (giving if the right to borrow at the prevailing rates of interest)
The bank receiving LIBOR and paying 5.75% can be said to have lent floating and borrowed fixed
Liability Swaps are simply swaps for borrowers of money
Asset Swaps are simply swaps for lenders of money
Futures are in 3 month time periods.
A buyer might want to buy a swap but say in 6 months time - Forward Swap
A buyer might want the option to buy a swap in 6 months time - Swaption
Amortising Swap - The notional amount in the swap is not constant, but reducing
This can apply when a swap backs a loan which some of the principal is constantly being repaid or a bond for which a sinking fund is being accumulated top redeem the bond.
Roller Coaster Swap - The notional principal at risk might also vary but up and down rather than declining.
Basis Swap - Both parties pay a floating rate.
Diff Swap - This is based on the difference between two rates
Currency Swap - Imagine you have a US investor who needs to raise French Francs but is not known to French Franc Investors. The solution is for the US investor to raise dollars , the French issuer to raise Francs and then swap the proceeds.
Cap - The interest rate cap sets a miximum level on a short-term rate interest rate. Buyers are compensated if the interest rate goes above a certain level (the strike level)
Floors - An investor, receiving income at floating rate, may buy a floor. This sets a minimum level to a rate of interest. The buyer is compensated if the market goes bleow this level.
Collars - Imagine simultaneously buying a cap at 6% and selling a floor at 4%. The net effect is to lock into a band of rates.
Caps, Floors and Collars are a series of interest rate options over a period of time.