What are Swaps?

In swap transactions, trading partners exchange debt securities with different interest rates, currencies and maturities. The purpose of swap transactions is to reduce financing costs. Swaps are not traded on exchanges, and retail investors do not generally engage in swap transactions. Instead, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customised to the needs of both parties. The financial instruments exchanged in a swap do not have to be interest payments. There are countless varieties of exotic swap agreements. The most common arrangements include credit default swaps, swaptions, vanilla swaps, commodity swaps, currency swaps, debt swaps, and total return swaps.

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Let’s go through a few of them.

Commodity swaps


These type of swaps involve the exchange of a floating commodity price, such as the Brent Crude oil spot price, for example, for a set price over an agreed-upon period. Commodity swaps most commonly involve crude oil.

Credit default swap


Credit default swaps (CDS) are a specific type of insurance against the default risks of a specific company. The company is referred to as the reference unit and the standard as the credit event. It is a contract between two parties that are referred to as the collateral taker and collateral provider. Under the agreement, the collateral taker is compensated for any loss arising from a credit event in a reference instrument. In return, the collateral taker makes periodic payments to the collateral provider. In the event of a default, the buyer receives the nominal value of the bond or loan from the guarantor. From the seller’s point of view, CDS provides a source of easy money if there is no credit event. It was JP Morgan that introduced CDS.

Payer Swap


A call option on a swap where the buyer has the right, but not the obligation, to enter into a swap (an exchange) where he pays the fixed interest rate and receives the variable interest rate. Payer swaps gain value when interest rates rise and, vice versa, lose value when interest rates do down. This type of swap is also often referred to as call swaption.

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Receiver swap


Put option on a swap (an exchange) where the buyer has the right, but not the obligation, to enter into a swap by paying the floating rate and receiving the fixed price. Receiver swaps gain value when interest rates fall and vice versa. The swap rate for a receiver swap, where the floating rate section is linked to the London Interbank Offered Rate (LIBOR), is the fixed payment that offsets the floating rate value and the fixed-rate value of the swap. A receiver swap is sometimes also called as a put swaption.

Both put and call swaptions are over-the-counter (OTC) contracts and are not standardised like equity options or futures contracts. Therefore, the buyer and seller need to agree on the price of the swaption, the time until the expiration of the swaption, the notional amount, and the fixed and floating rates.

Vanilla swap


A vanilla swap is a standard swap structure in which swaps have general or well-defined features, in particular with regard to coupons, notional amount, swap legs, and so on. For example, a vanilla interest rate swap is an agreement whereby a company undertakes to pay a stream of cash flows of interest at a predefined fixed interest rate on a notional amount for a specified period of time. In return, the company receives a commitment from a counterparty to pay a stream of cash flows calculated as interest at a floating rate with the same nominal amount for the same period. This form of swap is the simplest and does not include any add-ons or additional features. Initially, most vanilla swaps have no economic value, i.e. none of the counterparties would be obliged to pay any amount to the other at this early stage. Vanilla swaps (as opposed to flavoured swaps) are also called basic swaps.

Summary


A financial swap contract is a derivative contract where one party exchanges the cash flows or value of one financial asset for another. As an example, a company paying a variable rate of interest may swap its interest payments with another firm that will then pay the first company a fixed rate. Swaps can also be utilised to exchange other kinds of value or risks like the potential for a credit default in a bond.

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