CFA Level 1

By Investopedia AAA

Derivatives - Swap Markets and Contracts

Swaps are non-standardized contracts that are traded over the counter (OTC). However, to facilitate trading, market participants have developed the ISDA Master Agreement, which covers the 'non-economic' terms of a swap contract, such as representations and warranties, events of default and termination events. Parties to the trade still need to negotiate the rate or price, notional amount, maturity, collateral, etc.

Swaps are contracts that exchange assets, liabilities, currencies, securities, equity participations and commodities. Some are simple, such as floating-for-fixed-rate loans or Japanese yen for British pound sterling, while others are quite complex incorporating multiple currencies, interest rates, commodities and options. Both types are flexible in terms of specifications such as pricing or evaluation benchmarks, timing or contractual horizons, settlement procedures, resets, and other variables.

Generally, swaps are used for risk management by institutions such as banks, brokers, dealers and corporations. Some qualified individuals may also be suitable users of these basic derivatives products. The following lists highlight common swaps transactions.

  • Commodities: agricultural, energy, metals
  • Currencies: amortization or amortizing, differential, forward rates, forward start
  • Equities: basket, differential or spread, indexed, individual security related
  • Interest Rates: amortization or amortizing, arrears, basis, fixed for floating, forward start, inverse floater, zero coupon

Swap Characteristics

  • Most involve multiple payments, although one-payment contracts are possible
  • A series of forward contracts.
  • When initiated, neither party exchanges any cash; a swap has zero value at the beginning.
  • One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that both parties pay each other on the movement of an underlying asset.
  • Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other. This is called netting.
  • Final payment is made on the termination date.
  • Usually traded in the over-the-counter market. This means they are subject credit risk.

Terminating a Swap Contract
The easiest way to terminate the contract is to hold it to maturity. However, if one or both parties in a swap contract wish to terminate, there are several methods:

  1. Enter into a separate and offsetting swap. For example, an entity has a swap on its books that pays a fixed rate and receives a floating rate based on LIBOR on January 1 and July 1. The entity can enter into a new swap that pays a floating rate based on LIBOR and receives a fixed rate with payments on January 1 and July 1. With this new transaction, your fixed rates may be different because of market rates, while the LIBOR payments will wash out over the transaction's life. Credit risk will also increase because you could have a new counterparty for the new swap.
  2. The other way is to have a cash settlement based on market value. For example, assume that a party holds a swap with a market value of $65,000. The contract could be terminated if the other party pays the market value of the contract to the holder. Said another way, if the party holding the swap has a negative value, it can terminate the swap by paying its counterparty the market value of the swap. This terminates the contract for both parties, but this is usually available only if it is stated before the contract is entered into or agree upon by both parties at a later date.
  3. Another way to terminate a swap is to sell the swap to another party. This usually requires permission from the other party. This is not commonly used in the market place.
  4. The last way to terminate a contract is to use a swaption. A swaption works like an option by giving the owner the right to enter into another swap at terms that are set in advance. By executing the swaption, the party can offset its current swap as explained in the first way to terminate a contract.
Currency Swaps
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