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.
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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.