An Introduction To Swaps

Derivatives contracts can be divided into two general families:

1. Contingent claims, e.g. options

2. Forward claims, which include exchange-traded futures, forward contracts and swaps

SEE: Options Basics

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.

The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.

SEE: Futures Fundamentals

The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market.

Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.

SEE: How do companies benefit from interest rate and currency swaps?

For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:

  • Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
  • Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.

LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example).

SEE: Corporate Use Of Derivatives For Hedging

Figure 1: Cash flows for a plain vanilla interest rate swap


Plain Vanilla Foreign Currency Swap
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

eurodollar
Figure 2: Cash flows for a plain vanilla currency swap, Step 1.


Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.

As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3


Who Would Use a Swap?
The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.

Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By then using a currency swap, the firm ends with the euros it needs to fund its expansion.

Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this:

1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.

2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty.

4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.

The Bottom Line
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.

More From Investopedia

--

Get stories like this on the Yahoo app and discover more every day.
Download it now.
Loading...
  • Anchorvale Lane EC site draws 16 bids
    Anchorvale Lane EC site draws 16 bids The Edge Property - 8 minutes ago

    The tender for Anchorvale Lane executive condo site in Sengkang has been closed after attracting 16 bids, according to HDB.“The tender results reflect a close race amongst the market’s seasoned players,” says Desmond Sim, Head, CBRE Research, … More »

  • Oil prices fall on U.S. crude stocks build; fears over China demand Reuters - 14 minutes ago

    Oil prices fell early on Wednesday as an unexpected build in U.S. crude stocks weighed on markets, along with concerns that Chinese crude demand could falter as Beijing clamps down on alleged tax evasion in the oil industry. International Brent … More »

  • Mind the air-gap: Singapore's web cut-off balances security, inconvenience Reuters - 32 minutes ago

    Singapore is working on how to implement a policy to cut off web access for public servants as a defence against potential cyber attack - a move closely watched by critics who say it marks a retreat for a technologically advanced city-state that has … More »

  • Cat Cafes In Singapore - Which Ones Are Value For Money?
    Cat Cafes In Singapore - Which Ones Are Value For Money? GET.com - 35 minutes ago

    For all you kitty lovers who don't have cats of your own, cat cafes are important establishments... … More »

  • 4 Signs It's Time To Change Your Life
    4 Signs It's Time To Change Your Life GET.com - 35 minutes ago

    Are you a stressed out Singaporean who's often too fatigued to care about how you're actually... … More »

  • Dollar edges up, as investors wait on Fed, Jackson Hole
    Dollar edges up, as investors wait on Fed, Jackson Hole Reuters - 49 minutes ago

    The dollar edged up on Wednesday, moving off lows touched against the yen overnight, as markets looked to a gathering of global central bankers in Jackson Hole, Wyoming for clues on whether the Federal Reserve is poised to hike interest rates again. … More »

  • Asian stocks consolidate after Wall Street gains, oil slips Reuters - 54 minutes ago

    By Saikat Chatterjee HONG KONG (Reuters) - Asian stocks consolidated a recent run of gains on Wednesday, helped by Wall Street's rise overnight, even as oil prices slid on trade data showing a surprise ... … More »

  • Oil Declines on Glut Concern as Asian Shares Rise; Rand Rebounds Bloomberg - 1 hour 1 minute ago

    Crude dropped as much as 1.3 percent in New York after American Petroleum Institute figures showed that U.S. inventories increased by 4.46 million barrels last week. Shares rose in Japan and Australia, while stock index futures foreshadowed gains … More »

  • China’s Postal Bank Said to Seek Approval for $8 Billion IPO (1) Bloomberg - 1 hour 10 minutes ago

    The Beijing-based bank plans to seek approval from the Hong Kong bourse on Aug. 25, according to the people, who asked not to be identified as the information is private. Postal Savings Bank, ubiquitous in small-town China, joins Bank of Tianjin … More »

  • Qantas Pays First Dividend Since 2009 After Record Profit (2) Bloomberg - 1 hour 22 minutes ago

    The nation’s biggest carrier will pay a final dividend of 7 Australian cents a share and buy back as much as A$366 million ($279 million) of stock, according to a filing Wednesday. Joyce, who has cut thousands of jobs, deferred aircraft orders and … More »

  • Tokyo stocks extend global rally in opening trade AFP - 1 hour 23 minutes ago

    Tokyo stocks opened higher on Wednesday, extending a rally on global markets. The benchmark Nikkei 225 index climbed 0.32 percent, or 52.85 points, to 16,550.21 in opening deals, while the broader Topix ... … More »

  • MLQU is home in QC
    MLQU is home in QC Philippine Star - 1 hour 35 minutes ago

    Following exponential growth in its law enrollment rate in school year 2015-2016, Manuel L. Quezon University made another significant move to Quezon City last Aug. 19, coinciding with the 138th birth anniversary of the city’s visionary and former … More »

  • 4 Major Misconceptions Singaporeans Have About Their Critical Illness Insurance Plan DollarsAndSense.sg - 1 hour 37 minutes ago

    Find out if you have the same misconceptions about your critical illness insurance The post 4 Major Misconceptions Singaporeans Have About Their Critical Illness Insurance Plan appeared first on DollarsAndSense.sg. … More »

  • North Korea Successfully Launches Ballistic Missile From Sub Bloomberg - 1 hour 48 minutes ago

    The missile flew about 500 kilometers, suggesting the nation’s missile technology has improved from previous launches, a South Korean defense ministry official said. The missile was fired at about 5:30 a.m. from waters near the city of Sinpo where … More »

  • Australia carrier Qantas soars to record profits
    Australia carrier Qantas soars to record profits AFP News - 2 hours 5 minutes ago

    Australian carrier Qantas on Wednesday soared to a record annual net profit and announced a first payout to shareholders in seven years in a strong turnaround after major restructuring. Underlying profit before tax -- Qantas' preferred measure -- … More »

  • China Foods Mulls Sale of Mainland Coca-Cola Bottling Stakes Bloomberg - 2 hours 16 minutes ago

    China Foods is considering a sale of its stakes in 10 Coca-Cola bottling companies in the country through a public tender, it said in a Hong Kong stock exchange filing Tuesday. The company will sell stakes varying from 7.15 percent to 100 percent … More »

  • World Bank's Kim launches bid for second term as president
    World Bank's Kim launches bid for second term as president Reuters - 3 hours ago

    World Bank President Jim Yong Kim on Tuesday formally launched a bid for a second five-year term as head of the multilateral development lender, whose board pledged an "open, merit-based, and transparent" selection process. The notification … More »

  • Housing sector lifts U.S., European stocks; oil pares gains
    Housing sector lifts U.S., European stocks; oil pares gains Reuters - 3 hours ago

    By Hilary Russ NEW YORK (Reuters) - Homebuilders provided a modest lift to both U.S. and European stock markets on Tuesday, while oil prices got a brief boost from Iran's positive signals on an output ... … More »

  • Pound gains but rand plunges on finance minister probe AFP - 3 hours ago

    The British pound edged higher on the dollar Tuesday but South Africa's rand plunged after Finance Minister Pravin Gordhan was summoned by police. The pound gained after eurozone purchasing manager data ... … More »

  • Oil up on Iran talk; stockpile build cited by API surprises
    Oil up on Iran talk; stockpile build cited by API surprises Reuters - 4 hours ago

    Oil prices rose on Tuesday after Reuters reported Iran was sending positive signals that it may support joint OPEC action to prop up the market, before the market pared gains on trade data showing a surprise build in U.S. crude stocks. Iran, the … More »

  • China Distance posts 3Q profit Associated Press - 4 hours ago

    The Beijing-based company said it had profit of 22 cents per share. Earnings, adjusted for stock option expense, were 23 cents per share. The online education company posted revenue of $30.8 million in ... … More »

  • Era of the Raider Dawns in China, Where Vanke No Longer Immune Bloomberg - 4 hours ago

    While the battle for China Vanke Co. isn’t exactly the "Barbarians at the Gate" takeover of RJR Nabisco by private equity firm Kohlberg Kravis Roberts & Co. during the leveraged-buyout boom of the 1980s, the scale and significance may turn out to be … More »

  • Japan’s GLM Seeks to Cash in on China’s Electric Vehicle Boom Bloomberg - 4 hours ago

    The Kyoto-based automaker is close to signing deals to supply vehicle platforms for about 10 carmakers, including some in China, founder and CEO Hiroyasu Koma said in an interview, without naming them. The company is in discussions with other … More »

  • Analysts Gloomy on Hong Kong’s Exchange After Shenzhen Link News Bloomberg - 4 hours ago

    The proportion of sell recommendations is at its highest level since 2013, according to data compiled by Bloomberg, and price estimates suggest an 8.6 percent stock decline in the next 12 months. “There’s no more optimism in the short term -- the … More »

  • Chinese Insurance Giant Anbang Said to Seek Bank Pitches for IPO Bloomberg - 4 hours ago

    “A Hong Kong IPO would give Anbang a good fundraising channel plus some fresh capital for business expansion, including deals,” Steven Lam, a Hong Kong-based analyst at Bloomberg Intelligence, said by phone Tuesday. … More »

 
Recent Quotes
Symbol Price Change % Chg 
Your most recently viewed tickers will automatically show up here if you type a ticker in the "Enter symbol/company" at the bottom of this module.
You need to enable your browser cookies to view your most recent quotes.
 
Sign-in to view quotes in your portfolios.

MARKET MOVERS

  • Most Actives
    Most Actives
    NamePriceChange% Chg
    0.131+0.002+1.55%
    N21.SI
    0.59+0.03+4.80%
    5TP.SI
    0.155+0.006+4.03%
    AFC.SI
    2.79-0.02-0.71%
    C52.SI
    0.99+0.02+2.06%
    H64.SI
  • % Gainers
    % Gainers
    NamePriceChange% Chg
    0.225+0.010+4.65%
    BKW.SI
    2.44+0.07+2.91%
    P34.SI
    0.125+0.002+1.63%
    A50.SI
    1.165+0.015+1.30%
    A23.SI
    0.56-0.01-1.75%
    BMT.SI
  • % Losers
    % Losers
    NamePriceChange% Chg
    0.345-0.015-4.17%
    D03.SI
    0.245-0.005-2.00%
    RC5.SI
    0.665+0.005+0.76%
    AVM.SI
    0.300.000.00%
    5OT.SI
    0.465-0.005-1.06%
    5JS.SI

Market Data

  • Currencies
    Currencies
    NamePriceChange% Chg
    1.3517+0.0004+0.03%
    USDSGD=X
    1.5283+0.0013+0.09%
    EURSGD=X
    1.7822-0.0005-0.03%
    GBPSGD=X
    74.1060-0.0030.00%
    SGDJPY=X
    5.7321-0.0034-0.06%
    SGDHKD=X
    2.9868+0.011+0.37%
    SGDMYR=X
    9,794.1934-22.5107-0.23%
    SGDIDR=X
    4.9153+0.0019+0.04%
    SGDCNY=X
    1.0291+0.0002+0.02%
    AUDSGD=X
  • Commodities
    Commodities
    NamePriceChange% Chg
    1,343.10-3.00-0.22%
    GCZ16.CMX
    18.94+0.02+0.10%
    SIU16.CMX
    103.89-1.81-1.72%
    ^XAU
    2.120.00+0.19%
    HGU16.CMX
    47.65-0.45-0.94%
    CLV16.NYM
  • Bonds
    Bonds
    TreasuryYield (%)Yield Change
    1.14+0.01
    ^FVX
    1.55+0.01
    ^TNX
    2.240.00
    ^TYX