An Introduction to Swaps:

In finance, a swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. Usually at the time when 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. The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding is more thn $426.7 trillion in 2009, according to International Swaps and Derivatives Association (ISDA).

Swap market
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG. The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world productwhich is also a cash-flow

measure. Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by the British Bankers Association, an independent trade body.

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: 1. Interest rate swaps, 2. Currency swaps, 3. Credit swaps, 4. Commodity swaps 5. Equity swaps. There are also many other types of swaps.

Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap'

their existing obligation for their desired obligation. Normally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets while other companies have a comparative advantage in floating rate markets. When companies want to borrow they look for cheap borrowing i.e. from the market where they have comparative advantage. However this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. it is also a very crucial uniform pattern in individuals and customers.

Commodity swaps
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.

Other variations
There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.

A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.

An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap.

A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.

An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.

A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes.

A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future.

An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.

A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.

Valuation
The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative. There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:

Vswap = Bdomestic S0Bforeign, where Bdomestic is the domestic cash flows of the swap, Bforeign is the foreign cash flows of the LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1month deposits, 3-month LIBOR for three months deposits, etc. LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the international market.

Arbitrage arguments
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible. Derivatives contracts can be divided into two general families: 1. Contingent claims, i.e., options
2. Forward claims, which include exchange-traded futures, forward contracts and swaps

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. (For background reading, see Futures Fundamentals and Options Basics.)

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. (For related reading, see How do companies benefit from interest rate and currency swaps?) For example, on December 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

December 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). (To learn more, read 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 (i.e., 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. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

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 * 3.50% = 1,400,000 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 thenprevailing 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 reexchange 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 (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., 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 well known. It will likely receive more favorable financing terms in the US. 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. Conclusion 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.