Type: Response Essays
Sample donated: Andrew Sherman
Last updated: December 29, 2019
Introduction A swap is an agreement or a derivative contract between two counterparties to exchange cash flows. This exchange takes place at specified future dates as mentioned in the contract. Ø Swaps do not trade on exchanges and are traded mostly over-the-counter (OTC). Ø Swaps are custom instruments and largely unregulated. Ø Subject to default risk. Ø Swaps typically require no payment by either party at the beginning of the contract. Ø Exchanges only the net amount owed from one party to the other. Types of Swaps 1.
Interest Rate Swap This is the most common type of swap which is a contract between two counterparties to exchange fixed payment cash flow for floating payment cash flow, or vice versa, based on a specified principal amount on specified dates in the future. It is mainly used to hedge the interest rate risk. Interest Rate Swaps do not require the exchange of the notional principal amount of the contract. Figure-1: Interest Rate Swap In the above example, Bank has given a loan to Party A based on a floating interest rate, LIBOR and Party A has made an agreement with Party B to pay fixed interest rate of 6%. Party B in return agrees to make payments to Party A based on a floating interest rate. The floating rate is tied to a reference rate(London Interbank Offered Rate, or LIBOR).
2. Currency Swap Currency Swap is also an agreement between two counterparties in which one counterparty makes payments denominated in one currency, while another counterparty makes payments in a second currency. Ø At the starting of the swap, the equivalent notional amounts are exchanged at the current exchange interest rate and during the length of the swap contract, each party pays the interest on the swapped principal loan amount. Ø At the end of the swap, the notional amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate.
The main advantage of currency swap is that it reduces interest rate risk and foreign exchange risk. 3. Total Return Swap (TRS) Ø It is a contract between two counterparties in which the credit protection buyer receives payments based on a fixed interest rate. While in return, he makes payments based on the return of an underlying asset, generally an equity investment. This is mainly used to hedge Credit Risk. Ø A total return swap is an agreement in which one party (total return payer) transfers the total economic performance of a reference obligation to the other party (total return receiver). Total Economic Performance includes income from interest and fees, gains or losses from market movements, and credit losses.
In return, TRS receiver pays a premium and also covers capital depreciation of the reference asset. Ø Risks and benefits: TRS payer enjoys capital depreciation risk being covered by TRS receiver and also gets premium on the reference asset. Risks assumed are Interest Rate risk if premiums are based on floating rates (rates might go down) and Default Risk by TRS receiver in case of a credit event. TRS receiver enjoys capital appreciation of large reference assets by paying a small premium compared to value of a reference asset.
Faces Interest Rate risk (may shoot) or reference asset value depreciates. 4. Credit Default Swaps (CDS) It is a contract between two counterparties in which the one counterparty (protection buyer) makes regular payments to another counterparty (protection seller). In return, the credit protection seller makes a payment when any credit event occurs. It is very similar to an insurance contract and mainly used to hedge Credit Risk. Termination of Swaps There are different ways to terminate the swap contract before the maturity: Ø Mutual Termination – This is a mutual agreement between two counterparties to terminate a contract in which cash payment has to be made by the party with negative value of the contract owes to the counterparty. Ø Offsetting contract – A swap can also be terminated indirectly by entering into a similar swap agreement with opposite position to the original swap in order to offset the existing positions. Ø Resale of swap – A swap can also be terminated by selling it to another counterparty.
This is an unusual method and permission of counterparty is required. Ø Swaption – A swaption is an option to enter into a swap at some later date by paying some premium amount. The option to enter into an offsetting swap provides an option to terminate an existing swap. Recent Trends and Advancements in Swaps In recent years, contracting in swaps have expanded into new markets, as well as into new versions of the basic product. For example, it is now possible to trade both Interest Rate and Currency Swaps that are denominated in more than 18 different currencies. The new Non Plain Vanilla Swap designs and related products include: – Ø Off-market swaps – These swaps set the fixed rate to be something other than the prevailing market rate so that an initial payment can be created at the origination of the agreement. Ø Varying notional principal swaps – In these swaps, the size of the deal either expands or contracts from one settlement date to the next according to a predetermined schedule. Ø Indexed amortizing rate swaps – In these swaps, the notional principal amount varies in response to changes in some market index (such as the level of LIBOR) during the agreement.
Atomic Swaps An atomic swap is a direct trade between two different cryptocurrencies running on two separate blockchains. It does not require any centralized exchange or any other trusted third party for the trade. This is quite an exciting technology and innovation which has not yet fully implemented but once it’s operational, it will allow users to trade and buy any cryptocurrency directly within their own wallets. The latest news is that the atomic swap between two cryptocurrencies, Bitcoin and Litecoin has been successfully completed. The biggest advantage of atomic swap is that it reduces financial risk, human error and manipulation.