Swap (finance)
In finance a swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instance interest rate risk. Another use is speculation.
Structure
Swaps are Over-the-counter (OTC) derivatives. This means that they are negotiated outside exchanges. They cannot be bought and sold like securities or futures contracts, but are all unique. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty.
The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC Derivatives market. At the end of 2004, this was USD 248.288 trillion (that is, USD 248,288 billion, or six times World GDP). The majority of this (USD 147.4 trillion) were interest rate swaps. These split by currency as:
| Notional outstanding in USD trillion | |||||
| Currency | End 2000 | End 2001 | End 2002 | End 2003 | End 2004 |
| Euro | 16.6 | 20.9 | 31.5 | 44.7 | 59.3 |
| US dollar | 13.0 | 18.9 | 23.7 | 33.4 | 44.8 |
| Japanese yen | 11.1 | 10.1 | 12.8 | 17.4 | 21.5 |
| Pound sterling | 4.0 | 5.0 | 6.2 | 7.9 | 11.6 |
| Swiss franc | 1.1 | 1.2 | 1.5 | 2.0 | 2.7 |
| Total | 48.8 | 58.9 | 79.2 | 111.2 | 147.4 |
- Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1]
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 set by the British Bankers Association, an independent trade body.
Interest Rate Swap
Interest Rate swaps are the most common type of swap. They typically exchange fixed rate payments against floating rate payments. Exceptions exist, such as floating-to-floating swaps (known as basis swaps).
Total return swap
A total return swap is a swap, where 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.
Equity Swap
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.
Valuation
The value of a swap is the net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future cash flows is equal to zero.
For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Were this not the case, an Arbitrageur, C, could:
- assume the position with the lower present value of payments, and borrow funds equal to this present value
- meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
- use the received payments to repay the debt on the borrowed funds
- pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.
See: Rational pricing; Arbitrage
Variations
Variations of swaps include cross currency swaps, amortizing swaps and so on.
Options
An option on a swap is called a swaption.
See also
External links
- swaps index, quantnotes.com
- GE restate earnings because interest rate swaps didn't meet SFAS 133 hedge accounting criteria
- Bank for International Settlements