What is swap?

n finance, a swap is a derivative in which two 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 (coupon) payments associated with such bonds. Specifically, two
counterparties agree to exchange one stream of cash flowsagainst 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 accrued and calculated.
[1]
Usually at the time when the contract is initiated, at least
one of these series of cash flows is determined by an uncertain variable such as an floating interest
rate, foreign exchange rate, equity price, or commodity price.
[1]

The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or
an option, the notional amount 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.
[2]
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 $348 trillion in 2010, according
to Bank for International Settlements (BIS).
Swap market[edit]
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, the largest
U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange 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. The majority of this (USD 292.0 trillion) was
due to interest rate swaps. These split by currency as:


The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid-2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008

Notional outstanding
in USD trillion
Currency End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0




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 but this rate is known to be rigged (Barclays and others
banks have been convicted in the 2010-2012 LIBOR scandal).

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps,
currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types of
swaps.
Interest rate swaps
Main article: Interest rate swap


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 cashflows 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 based on an underlying
commodity is traded for a fixed price over a specified period.
A Commodity swap is similar to a Fixed-Floating Interest rate swap. The difference is that in an Interest
rate swap the floating leg is based on standard Interest rates such as LIBOR, EURIBOR etc. but in a
commodity swap the floating leg is based on the price of underlying commodity like Oil, Sugar etc. No
Commodities are exchanged during the trade.
In this swap, the user of a commodity would secure a maximum price and agree to pay a financial
institution this fixed price. Then in return, the user would get payments based on the market price for the
commodity involved.
On the other side, a producer wishes to fix his income and would agree to pay the market price to a
financial institution, in return for receiving fixed payments for the commodity.
The vast majority of commodity swaps involve oil.

Credit default swaps
A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to
the seller and, in exchange, receives a payoff if an 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.
Subordinated risk swaps
A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder)
pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include
any form of equity, management or legal risk of the underlying (for example a company). Through
execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus,
general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those
instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.
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 Accrediting 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.