In popular culture, we understand a swap as being an exchange of items of similar value, be that real, or intrinsic. In other words, both parties perceive that they are getting at least equal value for what they are trading. Unlike a sale, where there is a clear buyer and a clear seller, a swap relies on both parties being buyers and sellers.
Swaps occur in investing and although they are a little more complicated than exchanging items in our lunchbox, they operate on the principle of exchanging items of similar value. However, unlike with swaps in our personal life, businesses that enter into a swap do so with the expectation that they will gain a benefit from the swap.
This article will define what a swap is, how it is different from other kinds of derivatives, and why companies may enter into a swap agreement. We’ll also define the most common types of swaps and provide examples of how swaps work.
What is a swap?
A swap is a form of a derivative instrument where two parties enter into a contract to exchange a sequence of cash flows. This exchange takes place on a specific date or at specific intervals as specified in the contract. However, unlike a true bartering arrangement, in a derivative swap, it is typical that one of the cash flows has an uncertain variable that will determine the cash flow going in one direction. Conceptually, a swap can be seen as one party taking a long position in one instrument and the other party taking a short position in that same instrument. Both parties are hoping to gain an advantage in the swap based on the movement of the financial instrument involved.
The most common swaps are interest rate swaps and currency swaps. Other types include equity swaps and commodity price swaps. We’ll give you a description of the most common swaps a little later in the article.
How is a swap different from other kinds of derivatives?
A simple way to think about this is: all swaps are derivatives but not all derivatives are swaps. A derivative instrument can be either exchange-oriented or traded over the counter (OTC). Swaps are OTC transactions and usually done through a bank. OTC derivatives are unregulated. Despite posing a greater risk for the counterparty, swaps make up a greater proportion of derivative transactions. Exchange-oriented derivatives are standardized.
The vast majority of swaps are conducted between firms and financial institutions. Because of the nature of these transactions, including the risk of default, it is very uncommon for individuals to enter into a swap arrangement.
Why do companies engage in swaps?
At their core, swaps are a way for companies to manage risk. With that in mind, here are a few of the more common reasons why two parties may agree to conduct a swap.
- They may have different investment objectives or repayment scenarios.
- They may see an increased benefit in switching to an alternative cash flow stream or a stream that has become newly available.
- They may have a need to create a hedge against the risk that they have undertaken due to loans where repayment is based on a floating rate.
Swaps are one way that companies can address these, and other, issues. One of the key features, and benefits, of swaps, is their flexibility. Companies can design and structure swaps based on terms they mutually agree to. This creates the ability to structure swaps in a variety of ways and for specific purposes.
Defining the most common kind of swaps
Interest Rate Swaps– In an interest rate swap, two parties exchange cash flows on interest-bearing investments or loans where one rate is fixed and the other is floating. Here’s an example:
Company X issues $1 million in five-year bonds with a variable annual interest rate of 2% as set by LIBOR. In almost every case, the London Interbank Offered Rate (LIBOR) determines the interest rate for interest rate swaps. In this case, LIBOR would be seen as being historically low and therefore, Company X may look for a partner to arrange a swap with to protect them against rising rates.
Company Y, on the other hand, is of the opinion that interest rates are going to stay where they’re at, o may even go lower. Therefore, they enter into a swap with Company X to fund their interest payments on the bond issue at the LIBOR rate (in this case 2%) plus an additional 1.3% interest. To complete the swap, Company X agrees to pay Company Y a fixed interest rate of 6% on a notional value (no actual principal changes hands) of $1 million for five years.
In this example, Company X will benefit from the swap if interest rates take a significant jump over the span of the contract. Conversely, Company Y will benefit from the swap if interest rates fall, stay flat, or rise gradually.
Currency Swaps– This type of swap takes advantage of the difference in the transactional value of capital, particularly with companies that are doing business in other countries. Essentially, a currency swap allows companies to take advantage of advantageous loan rates in their home countries while getting a hedge against changing currency (forex) rates while receiving the foreign capital they need to conduct business.
For example, Company A is looking to set up operations in another country may find the exchange rate works against them. However, they may be able to get a lower interest rate on the loan in their home country. Conversely, Company B is from the country Company A is looking to do business in. They are looking to set up operations in Company A’s country, but are facing similar challenges. The two companies agree to a currency swap in which each company receives the money they need in that country’s respective currency. In exchange, the companies agree to pay the interest rate on the other company’s loans.
Commodity Swaps– This kind of swap is common among companies (although it could be individuals) who use raw materials (commodities) to produce goods or finished products. Companies are looking to get a hedge against rising commodity prices that can affect their profit. A company’s profit can be affected by an increase in the costs of the raw material needed to make their products because the market can’t always absorb price increases that correspond to the rise in commodity prices.
As an example, let’s look at two companies whose businesses are reliant on crude oil. If the price of a barrel of crude oil is $60, but Company C thinks that the price of oil will rise, they will look to lock in that $60 price. Remember, swaps are at their core the idea of exchanging a fixed rate for a flexible (or floating) rate. They find Company D that is willing to receive a payment from the first company set at the price of $60 and will agree to pay Company C the floating rate. If the price of crude rises, Company D will have to pay Company C the difference in price. Similarly, if the price of crude declines, Company C will have to pay Company D the difference in price.
Credit Default Swaps (CDS)– This type of swap became popular immediately before the financial crisis. It amounts to a form of insurance that protects one party from the risk of default by a third party. As an example, if Fred purchases a five-year-long bond worth $1,000 and with a coupon rate of 5%, which means Fred is scheduled to receive $50 per year until maturity. However, Fred is concerned that the company that issued the bond may default. On the other hand, Bill is a strong believer in the company and, for that reason, enters into a Credit Default Swap with Fred.
In this arrangement, Fred (in this case the buyer) agrees to pay Bill (the seller) $20 per year in exchange for Bill taking on the default risk of the loan. If the company defaults, Bill agrees to pay Fred the principal and outstanding interest payments. If the company does not default, Bill does not make any payments to Fred.
Zero Coupon Swaps (ZCS)– This kind of swap is typically done as an interest rate hedge for loans that pay interest at the end of the loan (i.e. maturity date). These swaps are either done between a fixed rate and a floating rate (fixed-to-floating) or between two fixed rates (fixed-fixed). In a fixed-to-floating swap, the party paying the fixed rate only pays out at the end of the swap contract. The party paying the floating rate makes regular payments following the agreed upon payment schedule. In a fixed-fixed swap, the same principle applies where one party does not make any payments until maturity while the other party agrees to make interim payments.
Total Return Swaps (TRS)– This kind of swap allows the buyer of the swap to benefit from the potential income and capital appreciation (i.e. total return) of a security without actually owning the security. In exchange the seller of the swap agrees to pay the buyer pays the seller a fixed or floating interest rate payment.
Can a swap agreement be terminated early?
Like any contract, there are times when one or both of the swap parties need to end the contract prior to its termination date. The process for exiting a swap is similar to exiting a futures or options contract. There are four basic ways to do this.
- Buy Out – In theory, this would mean that exiting party pays the other party the market value of the swap. In practice, however, a buy out must be a negotiated feature of any swap. The easiest way to do this is to write it into the swap agreement, although it can be done when the buy out is needed with the other party’s consent.
- Negotiate an Offsetting Swap – In simple terms, if two companies had an interest rate swap, the exiting party could enter into a swap with a different party that would allow them to switch from a fixed rate to floating or vice versa.
- Third Party Sale – In this example, the exiting party would sell the swap to a third party. However, like the buy out option, this requires the consent of the other party.
- Swaption – As the name implies, this is an option on a swap. Purchasing a swaption allows a party to arrange, but not actually enter into, a swap that would offset their original swap. This must be created at the time they execute the original swap and is done to reduce the market risks that could come from having to negotiate an offsetting swap in the middle of a contract.
The bottom line on swaps
A swap is a form of a derivative instrument that allows two parties to negotiate cash flow terms for a specified period of time. In every swap, each party is entering into the contract with the hope of gaining an advantage over the other party. Although swaps may seem confusing, they can provide companies with a way to obtain financing at terms that meet their current needs, while providing a hedge against volatility in the market.
The most common types of swap are interest rate swaps and currency swaps. However, there are an almost endless variety of swaps based on the needs, and goals, of the two parties. Some other variations include:
- Commodity swaps
- Credit default swaps
- Zero coupon swaps
- Total return swaps
Similar to an options contract, there are ways for one party to exit a swap contract should the need arise. Some of these options may require the consent of the other party in the swap.