Swaps are contractual agreements between two parties who agree to exchange one set of cash flows for another. The two parties that agree to exchange the cash flows are called counterparties of the swaps.
The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchanges but they do have an Over-The-Counter (OTC) market and are traded among dealers.
Swaps can be effectively combined with other type of derivative instruments. For example: An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.
Swap can be classified as;
- Commodity swaps
- Interest rate swaps
- Currency swaps
- Equity swaps
- Credit default swaps
In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy, and agriculture.
For example: In a commodity swap, a party may agree to exchange cash flows linked to prices of oil for fixed cash flow.
Commodity swaps are used for hedging against changes in commodity prices or changes in spreads between final product and raw material prices (For example – Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)
A company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile.
This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange.
How do commodity swaps work
For example, consider a commodity swap involving a notional principal of 1,000,000 barrels (unit code: bbl) of crude oil. One party agrees to make fixed semi-annual payments at a fixed price of CU 2,500/bbl, and receive floating payments.
On the first settlement date, if the spot price of crude oil is CU 2,400/bbl, the pay-fixed party must pay (CU 2,500/bbl)*(100,000 bbl) = CU 250,000,000.
The pay-fixed party also receives (CU 2,400/bbl)*(100,000 bbl) =CU 240,000,000.
The net payment made (cash outflow for the pay-fixed party) is then CU 10,000,000.
In a different scenario, if the price per barrel will have increased to CU 2,550/bbl than the pay-fixed party would have received a net inflow of CU 5,000,000.
Interest rate SWAP
Here is an example of an interest rate SWAP as presented on Wikipedia (see link below)
More information: https://en.wikipedia.org/wiki/Swap_(finance)
Currency swaps have always been very convenient in finance. They allow for the re-denomination of loans or other payments from one currency to the other.
For large corporations, currency swaps offer the unique opportunity of raising funds in one particular currency and making savings in another. The risk for performing currency swap deals is very minimal, and on top of that, currency swaps are very liquid, and parties can settle on an agreement at any time during the lifetime of a transaction.
Early termination of a currency swap deal is also possible through negotiation between the parties involved.
Examples of Currency Swaps
In the past, currency swaps were done to circumvent exchange controls, but nowadays, they are done as part of a hedging strategy against forex fluctuations. They are also used to reduce the interest rate exposure of the parties involved or to simply obtain cheaper debt.
For instance, let’s say a US-based company ‘A’ wishes to expand into the UK, and simultaneously, a UK-based company ‘B’ seeks to enter the US market. As international companies in their prospective markets, both companies are unlikely to be offered competitive loans.
UK banks may be willing to offer company A loans at 12%, while US banks can only offer company B loans at 13%. However, both companies could have competitive advantages on their domestic turfs where they could obtain loans at 8%.
If both companies are seeking similar amounts in loans, company A would borrow from its US bank, while company B would borrow from its UK bank. Company A and B would then swap their loans and pay each other’s interest obligations.
In the case of different interest rates, both companies would have to work out a formula that reflects their representative credit obligation.
Another way to approach the swap would be for both company A and company B to issue bonds at underlying rates. They would then deliver the bonds to their swap bank, who will switch them over to each other.
Company A will have UK assets, while company B will have US assets. Interest from company A will go through the swap bank that will deliver this to company B, and vice versa.
As well, each company will, at maturity, pay the principal amount to the swap bank, and in turn, they will receive the original principal.
In both scenarios, each company has obtained the foreign currency it desired, but at a cheaper rate while also protecting itself again forex risk.
In an equity swap, two parties agree to exchange a set of future cash flows periodically for s specified period of time. Once leg of the equity swap is pegged to a floating rate such as LIBOR or is set as a fixed rate. The cash flows on the other leg are linked to the returns from a stock or a stock index. The leg linked to the stock or the stock index is referred to as the equity leg of the swap.
Let’s take an example to understand the various aspects of an equity swap. Let’s say an asset manager who manages a fund called Alpha Fund follows a passive investment strategy and his portfolio tracks the S&P 500 Total Returns Index. The asset manager can enter into an equity swap contract with a counterparty say Goldman Sachs with the following terms:
Notional Principal: $100 million
Alpha Fund pays: Total returns on the S&P 500 Index
Goldman Sachs pays: Fixed 6%
Payments to be made at the end of every six months, that is, 30th June and 31st December
The swap has a maturity of 3 years.
Let’s see how the cash flows turn out in the first year. At the beginning, the S&P Total Return Index was at 2500 level, on 30th June it was 2600, and on 31st December it was at 2570. Let’s look at the cash flows in both the legs of the transaction.
Let’s make a few observations from the above table:
- If the index returns are positive, Alpha Fund pays index returns to Goldman and Goldman pays fixed rate to Alpha.
- If the index returns are negative, Alpha pays nothing and Goldman pays the fixed rate plus any loss on the index returns. It’s as if Alpha sold out its positions in stocks and had a fixed rate position instead.
- The fixed payments are calculated on actual/365 basis.
- The amount of payment is not known till the last day of the payment.
- The net effect of the swap is that a position in an equity portfolio has been converted into a fixed income position.
An equity swap can be of three types: the first leg will be a fixed rate, a floating rate or an equity or index return, while the other let will always be an equity or index return. So, an equity swap can have both the legs as returns from two different equities or equity indexes.
Credit default SWAP
A default swap is a bilateral contract that enables an investor to buy protection against the risk of default of an asset issued by a specified reference entity. Following a defined credit event, the buyer of protection receives a payment intended to compensate against the loss on the investment. This is shown in Mechanics of a default Swap, below. In return, the protection buyer pays a fee. For short-dated transactions, this fee may be paid up front. More often, the fee is paid over the life of the transaction in the form of regular accruing cash flow. The contract is typically specified using the confirmation document and legal definitions produced by the International Swap and Derivatives Association (ISDA).
Despite the rapid moves toward the idea of a standard default swap contract, a default swap is still very much a negotiated contract. There are, therefore, several important features that need to be agreed between the counter parties and clearly defined in the contract documentation before a trade can be executed.
The first thing to define is the reference entity. This is typically a corporate, bank, or sovereign issuer. There can be significant difference between the legal documentation for corporate, bank, and sovereign linked default swaps.
The next step is the definition of the credit event itself. This is obviously closely linked to the choice of the reference entity and may include the following events:
- Bankruptcy (not relevant for sovereigns)
- Failure to pay
- Obligation acceleration/default
- Repudiation/Moratorium Restructuring
These events are now defined in the recent ISDA 1999 list of Credit Derivatives Definitions, which is described in great detail in Section 6.1.
Some default swaps define the triggering of a credit event using a reference asset. The main purpose of the reference asset is to specify exactly the capital structure seniority of the debt that is covered. The reference asset is also important in the determination of the recovery value should the default swap be cash settled (see Mechanics of a default Swap above). However, in many cases the credit event is defined with respect to a seniority of debt issued by a reference entity, and the only role of the reference asset is in the determination of the cash settled payment. Also, the maturity of the default swap need not be the same as the maturity of the reference asset. It is common to specify a reference asset with a longer maturity than the default swap.
The contract must specify the payoff that is made following the credit event. Typically, this will compensate the protection buyer for the difference between par and the recovery value of the reference asset following the credit event. This payoff may be made in a physical or cash settled form, i.e. the protection buyer will usually agree to do one of the following:
- Physically deliver a defaulted security to the protection seller in return for par in cash. Note that the contract usually specifies a basket of obligations that are ranked pari passu that may be delivered in place of the reference asset. In theory, all pari passu assets should have the same value on liquidation, as they have an equal claim on the assets of the firm. In practice, this is not always reflected in the price of the asset following default. As a result, the protection buyer who has chosen physical delivery is effectively long a “cheapest to deliver” option.
- Receive par minus the default price of the reference asset settled in cash. The price of the defaulted asset is typically determined via a dealer poll conducted within 14-30 days of the credit event, the purpose of the delay being to let the recovery value stabilise. In certain cases, the asset may not be possible to price, in which case there may be provisions in the documentation to allow the price of another asset of the same credit quality and similar maturity to be substituted.
- Fixed cash settlement. This applies to fixed recovery default swaps, which are described below.
The first two choices are shown in Mechanics of a default Swap above. If the protection seller has the view that either by waiting or by entering into the work-out process with the issuer of the reference asset he may be able to receive more than the default price, he will prefer to specify physical delivery of the asset.
Unless already holding the deliverable asset, the protection buyer may prefer cash settlement in order to avoid any potential squeeze that could occur on default.
Cash settlement will also be the choice of a protection buyer who is simply using a default swap to create a synthetic short position in a credit. This choice has to be made at trade initiation.