Swaps and the swap market for the most part are a mystery to everyday individual investors and casual followers of the financial markets. However, one might be surprised to learn about the sheer size of the swap market and the importance it plays in the global financial marketplace. In this article we will take a closer look at swaps and the swap market as a whole in the hopes demystifying what might be considered a confusing subject for many who don't deal with swaps on a regular basis.
TUTORIAL: Introduction To Options Greeks

Introduction to Swaps
A swap is a derivative instrument that permits counterparties to exchange (or "swap") a series of cash flows based on a specified time horizon. Typically, one series of cash flows would be considered the fixed leg of the agreement while the other would be less predictable, such as cash flows based on an interest rate benchmark or a foreign exchange rate, usually referred to as the floating leg. The swap agreement as it is known, which would be agreed upon by both parties, will specify the terms of the swap, including the underlying values for the legs along with the payment frequency and dates. A party would enter a swap typically for one of two reasons, as a hedge for another position or to speculate on the future value of the floating leg's underlying index/currency/etc.

For speculators looking to place bets on the direction of interest rates (such as hedge funds), interest rate swaps are an ideal instrument. While traditionally one would trade bonds to make such bets, by entering into either side of an interest rate swap agreement, you would gain immediate exposure to interest rate movements with virtually no initial cash outlay.

One major risk (other than the obvious interest rate risk) for swap investors is that of counterparty risk. Since any gains over the course of a swap agreement are considered unrealized until the next settlement date, timely payment from the counterparty determines profit. If the counterparty cannot meet their obligation you may be unable to collect your rightful payments.

Additionally, if one party decides it is time to exit a swap agreement, they have several options for a successful exit. With the swap market having so many participants, it can be relatively easy to sell your position to another party willing to take on the exposure. Also, much like with other derivatives the exiting party could simply just take an offsetting position in another swap to zero out the position. Other strategies include entering into an offsetting swap positions which effectively cancels out the original.

The Swap Market
Since swaps are highly customized and not easily standardized, the swap market is considered an over-the-counter market, meaning swap contracts cannot typically be easily traded on an exchange (however there are swap indexes available on some public exchanges). However, that does not mean that swaps are illiquid instruments, quite the contrary. The swap market is one of the largest and most liquid marketplaces in the world, with many willing participants in most cases ready to take either side of a contract to either hedge some sort of exposure or for speculation. It has been estimated that in 2009 the notional amount outstanding in over-the-counter interest rate swaps was nearing $350 trillion.

Types of Swaps

  • Plain Vanilla Swaps
    To better understand swaps we will take a closer look at how a plain vanilla swap works. Plain vanilla interest rate swaps are definitely the most common type of swap; they are widely used by governments, corporations, institutional investors, hedge funds and numerous other financial entities. In a plain vanilla swap, one party (Party X) agrees to pay the other party (Party Y) a fixed amount based upon a fixed interest rate and a notional dollar (or euro, or whatever currency) amount. In exchange, Party Y will pay Party X an amount based upon that same notional amount but also dependent on a floating interest rate, usually based upon LIBOR. The notional amount however is never exchanged between parties, as the next effect would be equal. At the time of inception the value of the swap to either party is zero; however, as the interest rates fluctuate over time the value of the swap too will fluctuate, with either Party X or Party Y having an equivalent unrealized gain to the other party's unrealized loss. Upon each settlement date, if the floating rate has appreciated relative to the fixed, the floating rate payer will owe a net payment to the fixed payer.

    For example, at initiation Party X had agreed to pay a fixed rate of 4% while receiving a floating rate of LIBOR+50 bps form Party Y on a notional amount of 1,000,000. At the time of the first settlement date LIBOR is 4.25%, meaning that the floating rate is now 4.75% and Party Y must make payment to Party X. The net payment would therefore be the difference between the two rates multiplied by the notional amount [4.75% - 4% *(1,000,000)], or $7,500.

  • Currency Swap
    In a currency swap, two counterparties aim to exchange principal amounts and pay interest payments in their respective currencies. Such swap agreements allow the counterparties to gain both interest rate exposure as well as foreign exchange exposure, as all payments are made in the counterparty's currency. For example, a U.S.-based firm wishes to hedge a future liability it has in the U.K., while a U.K.-based business wishes to do the same for a deal it is expecting to close in the United States. By entering into a currency swap, the parties can exchange an equivalent notional amount (based on the spot exchange rate) and agree to make periodic interest payments based on their domestic rates. The currency swap force both sides to exchange payments based upon fluctuations in both domestic rates and the exchange rate between the U.S. dollar and the pound over the life of the agreement. (Find out what makes currency swaps unique and slightly more complicated than other types of swaps. Check out Currency Swap Basics.)

  • Equity Swap
    An equity swap is similar to an interest rate swap; however, in an equity swap rather than one leg being the "fixed" side, it is based upon the return of an equity index. For example, one party will pay the floating leg (typically linked to LIBOR) and receive the returns on a pre-agreed upon index of stocks relative to the notional amount of the contract. If the index traded at a value of 500 at inception on a notional amount of $1,000,000, and after three months the index is now valued at 550, the value of the swap to the index receiving party has increased by 10% (assuming LIBOR has not changed). Equity swaps can be based upon popular global indexes such as the S&P 500 or Russell 2000, or can be made up of a customized basket of securities decided upon by the counterparties. (These derivatives allow investors to transfer risk, but there are many choices and factors that investors must weigh before buying in. Check out 5 Equity Derivatives And How They Work.)

  • Credit Default Swaps
    A credit default swap, or CDS, is a different type of swap, in that the traditional counterparty-periodic payment structure does not exact in the same way as other types of swaps. A CDS can be viewed almost as a type of insurance policy, by which the purchaser of the CDS will make periodic payments to the issuer in exchange for assurance that if the underlying fixed income security goes into default, the purchaser will be reimbursed for the loss. The payments, or premium, is based upon the default swap spread for the underlying security, also referred to as the default swap premium.

    For example, a portfolio manager holds a $1 million bond (par value) and wants to protect his portfolio from a possible default. He can seek a counterparty willing to issue him a credit default swap (typically an insurance company) and pay the annual 50 basis point swap premium to enter into the contract. So, every year the portfolio manager will pay the insurance company $5,000 ($1,000,000 x 0.50%) as part of the CDS agreement, for the life of the swap. If in one year the issuer of the bond defaults on its obligations and the bond's value falls 50%, the CDS issuer is obligated to pay the portfolio manager the difference between the bond's notional par value and its current market value, $5,000,000. (This derivative can help manage portfolio risk, but it isn't a simple vehicle. See Credit Default Swaps: An Introduction.)

The Bottom Line
This was just a quick look at swap agreements and the swap market and there are many other types of swaps and features that can be added to the discussion. What's important to remember is that swaps are very popular derivative instrument utilized by parties of all types to meet their specific investment strategies.

Related Articles
  1. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  2. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  3. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  4. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  5. Mutual Funds & ETFs

    The 8 Most Popular Vanguard Funds for a 401(k)

    Learn about some of the mutual funds in Vanguard's lineup that are popular among 401(k) investors, and find out why you should consider them.
  6. Mutual Funds & ETFs

    How to Reinvest Dividends from ETFs

    Learn about reinvesting ETF dividends, including the benefits and drawbacks of dividend reinvestment plans (DRIPs) and manual reinvestment.
  7. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  8. Home & Auto

    5 Mistakes That Make House Flipping A Flop

    If you're just looking to get rich quick, you could end up in the poorhouse.
  9. Entrepreneurship

    Top 10 Features Of a Profitable Rental Property

    Find out which factors you should weigh when searching for income-producing real estate.
  10. Mutual Funds & ETFs

    Best 3 Vanguard Mutual Funds for Retirement

    Discover the top Vanguard target-date retirement funds with target dates in 2020, 2030 and 2050, and learn about the characteristics of these funds.
  1. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  4. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  5. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center