In finance, a swap is a derivative where two counterparts exchange cash flows streams.
Example: Company A owns the financial instrument NNN, while Company B owns the financial instrument PPP. Through a swap, they arrange for Company A to receive the cash flow form PPP and Company B to receive the cash flow from NNN.
Each cash flow is called a leg. In most swaps, at least one of the swap’s legs will be highly affected by some uncertain variable, e.g. foreign exchange rate, commodity price or floating interest rate.
The swap agreement will specify details, e.g. the dates when cash flows are to be paid, how cash flows are accrued and how cash flows are calculated.
Swaps are used both for hedging (mitigating risks) and for speculation.
Although some swaps are traded on future exchanges (especially on the Chicago Mercantile Exchange, the Chicago Board Options Exchange, the Intercontinental Exchange, and the Eurex AG) most swaps are traded over-the-counter (OTC).
Swaps traded on exchanges are standardized, while swaps traded OTC can be highly customized to suit the counterparts.
Examples of swap types
Interest rate swaps
This is a very common type of swap.
Example: Company A is paying interest on a fixed rate loan. Company B is paying interest on a floating rate loan. Company B dislikes not knowing the future interest costs for its loan, and makes a 10 year long interest rate swap with Company A.
It is common for counterparts to use a bank as an intermediary and set up two swaps with the bank instead of a direct swap between the counterparts. (The bank profits by taking spread from the swap payments.)
An interest rate swap where the notional principal for the interest payments decline during the swap’s lifetime is known as an amortising swap.
A currency swap will typically consists of exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on another (equal) loan in another currency.
This type of swap often concerns crude oil, but can be made for any commodity. A floating price, market price or spot price is exchanged for a fixed price over a predetermine period of time.
Credit default swaps (CDS)
A credit default swap (CDS), also known as a credit derivative contract, is a swap designed to transfer the credit exposure of fixed income products from one counterpart to another.
The purchaser of the swap will make payments to the seller of the swap, until the maturity date of a contract. Ín return, the seller pays off a third party debt if this party defaults on the loan. As you see, a CDS can be seen as a form of insurance against third party default. The seller of the swap guarantees the credit worthiness of the debt security.
There are credit default swaps that are not designed to offer the purchaser protection against a third party default, but against other events – such as the third party filing for bankruptcy or get their credit rating downgraded below a certain level.
Subordinated risk swaps / Equity risk swaps
A company normally have liabilities in the form of legal risks, management risks and similar. There is for instance always a risk that one of the managers does something that forces the company to pay compensation to an injured party.
If a company wish to transfer this type of risk (general or special entrepreneurial risks), a subordinated risk swap / equity risk swap can be utilized. This is a contract where the buyer pays a premium to the seller to have one or more of this type of risks transferred.
This is still a fairly unusual type of swap and there are only a few investors world wide that specializes in selling subordinated risk swaps / equity risk swaps.
Total return swap
This is a swap where one of the counterparts agree to pay the total return of an asset while the other counterpart makes periodic interest payments. (Total return = capital gain or loss + any interest or dividend payments.)
A swaption is an option on a swap. The holder of a swaption has the right, but not the obligation, to enter into a specific swap at a predetermined future date or dates.
Forward swap / Delayed start swap / Deferred start swap
This is an agreement formed by the amalgamation of two swaps of different lifetimes. It is done to fulfill of one of the counterparts’ time-frame needs.