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Infinance, aswap is aderivative contract between twocounterparties to exchange, for a certain time,financial instruments,unconventional cashflows, or payments. Most swaps involve the exchange of interest rate cash flows, based on anotional principal amount.[1][2]
Unlikefuture,forward oroption contracts, swaps do not usually involve the exchange of theprincipal during or at the end of the contract.[3] In general, one cash flow, or leg, of the swap is generally fixed, while the other isfloating and determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price.[4]
Swaps are primarilyover-the-counter contracts between companies or financial institutions.Retail investors do not generally engage in swaps.[5] They are often used tohedge certain risks, such asinterest rate risk, or tospeculate on the expected direction of underlying prices.[6]
Swaps were first introduced to the public in 1981 whenIBM and theWorld Bank entered into a swap agreement.[7] Today, swaps are among the most heavily traded financial contracts in the world; the total amount of interest rate and currency swaps outstanding was more than $348 trillion in 2010, according toBank for International Settlements.[8]
Most swaps are tradedover-the-counter and are drafted specifically for the counterparties. The United States'sDodd-Frank Act in 2010, however, established a multilateral platform for swap quoting, theswaps execution facility,[9] mandating that swaps be reported to and cleared through exchanges orclearing houses. This subsequently led to the formation ofswap data repositories (SDR), a central facility for swap data reporting and recordkeeping.[10] Data vendors, such as Bloomberg,[11] and large exchanges, such as theChicago Mercantile Exchange,[12] were among the first to register as SDRs. Other exchanges followed, such as the IntercontinentalExchange and Frankfurt-based Eurex AG.[13]
According to the 2018 SEF Market Share Statistics,[14] Bloomberg dominates the credit rate swap market with 80% share; TP dominates the FX dealer to dealer market (46% share); Reuters dominates the FX dealer to client market (50% share); Tradeweb is strongest in the vanillainterest rate swap market (38% share); TP is the biggest platform in thebasis swap market (53% share); BGC dominates both theswaption and XCS markets; Tradition is the biggest platform forcaps and floors (55% share).
While the market for currency swaps developed first, the interest rate swap market has surpassed it, measured bynotional principal, "a reference amount of principal for determining interest payments."[15]
TheBank for International Settlements (BIS) publishes statistics on thenotional amounts outstanding in the OTCderivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the2006 gross world product. However, since thecash 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 product—which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due tointerest rate swaps. These split by currency as:
| Currency | Notional outstanding (in USD trillion) | ||||||
|---|---|---|---|---|---|---|---|
| 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 |
A Major Swap Participant (MSP, or sometimes Swap Bank) is a generic term to describe afinancial institution that facilitates swaps between counterparties. It maintains a substantial position in swaps for any of the major swap categories. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. A swap bank serves as either a swap broker or swap dealer. As a broker, the swap bank matches counterparties but does not assume any risk of the swap. The swap broker receives a commission for this service. Today, most swap banks serve as dealers or market makers. As a market maker, a swap bank is willing to accept either side of a currency swap, and then later on-sell it, or match it with a counterparty. In this capacity, the swap bank assumes a position in the swap and therefore assumes some risks. The dealer capacity is obviously more risky, and the swap bank would receive a portion of thecash flows passed through it to compensate it for bearing this risk.[1][16]
The two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about throughcomparative advantages each counterparty has in its nationalcapital market, and/or the benefit of hedging long-runexchange rate exposure.[citation needed] These reasons seem straightforward and difficult to argue with, especially to the extent that name recognition is truly important in raising funds in the internationalbond market.[opinion] Firms using currency swaps have statistically higher levels of long-term foreign-denominated debt than firms that use no currency derivatives.[17] Conversely, the primary users of currency swaps are non-financial, global firms with long-term foreign-currency financing needs.[18] From a foreign investor's perspective, valuation of foreign-currency debt would exclude theexposure effect that a domestic investor would see for such debt. Financing foreign-currency debt using domestic currency and a currency swap is therefore superior to financing directly with foreign-currency debt.[18]
The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a cost savings via thequality spread differential (QSD).[citation needed] Empirical evidence[citation needed] suggests that the spread between AAA-rated commercial paper (floating) and A-rated commercial is slightly less than the spread between AAA-rated five-year obligation (fixed) and an A-rated obligation of the same tenor. These findings suggest that firms with lower (higher) credit ratings are more likely to pay fixed (floating) in swaps, and fixed-rate payers would use more short-term debt and have shorter debt maturity than floating-rate payers. In particular, the A-rated firm would borrow using commercial paper at a spread over the AAA rate and enter into a (short-term) fixed-for-floating swap as payer.[19]
The generic types of swaps, in order of their quantitative importance, are:interest rate swaps,basis swaps,currency swaps,inflation swaps,credit default swaps,commodity swaps andequity swaps. There are also many other types of swaps.
The most common type of swap is an interest rate swap. 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 avariable interest rate ofLIBOR +70basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over thenotional amount. The first rate is calledvariable because it is reset at the beginning of each interest calculation period to the then currentreference rate, such asLIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.
A basis swap involves exchanging floating interest rates based on different money markets. The principal is not exchanged. The swap effectively limits the interest-rate risk as a result of having differing lending and borrowing rates.[20]
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 bycomparative advantage.Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one directionbeing in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.
An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms. The primary objective is to hedge against inflation and interest-rate risk.[21]
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involvecrude oil.
An agreement whereby the payer periodically pays premiums, sometimes also or only a one-off or initial premium, to the protection seller on a notional principal for a period of time so long as a specifiedcredit event has not occurred.[22] The credit event can refer to a single asset or a basket of assets, usually debt obligations. In the event of default, the payer receives compensation, for example the principal, possibly plus all fixed rate payments until the end of the swap agreement, or any other way that suits the protection buyer or both counterparties. The primary objective of a CDS is to transfer one party's credit exposure to another party.
A subordinated risk swap (SRS), or equity risk swap, is a contract in which thebuyer (or equity holder) pays a premium to theseller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of theunderlying (for example acompany). 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 tradedover-the-counter (OTC) and there are only a few specialized investors worldwide.
An agreement to exchange future cash flows between two parties where one leg is an equity-based cash flow such as the performance of a stock asset, a basket of stocks or a stock index. The other leg is typically a fixed-income cash flow such as a benchmark interest rate.
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.[4]
The value of a swap is thenet present value (NPV) of allexpected future cash flows, essentially the difference in leg values. A swap is thus "worth zero" when it is first initiated, otherwise one party would be at an advantage, and arbitrage would be possible; however after this time its value may become positive or negative.[4]
While this principle holds true for any swap, the following discussion is for plain vanilla interest rate swaps and is representative of pure rational pricing as it excludescredit risk. For interest rate swaps, there are in fact two methods, which will (must) return the same value: in terms ofbond prices, or as a portfolio offorward contracts.[4]The fact that these methods agree, underscores the fact that rational pricing will applybetween instruments also.
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.
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 thefixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of theexpected future floating rate payments (i.e. the NPV is zero). Where this is not the case, anArbitrageur, C, could:
Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarlyshort sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short.
While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in afixed-rate bond (i.e.receiving fixed interest payments), and a short position in afloating rate note (i.e.making floating interest payments):
From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,
Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:
LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the international market.
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