Swaps are derivative instruments that involve an agreement between two parties to exchange a series of cash flows over a specific period of time .(See related: An Introduction To Swaps.) 

There are multiple reasons why parties agree to such an exchange:

  • Investment objectives or repayment scenarios may have changed.
  • It may be financially beneficial to switch to newly available alternate stream of cash flows compared to the existing one.
  • Hedging can be achieved through swaps, like mitigation of risk associated with a floating rate loan repayment.

Being OTC products, swaps offer great flexibility to design and structure contracts based on mutual agreement. This flexibility leads to a lot of swap variations, each serving a specific purpose. We will look at different types of swaps and how each participant in the swap benefits.

  • Interest Rate Swaps

The most popular types of swaps are plain vanilla interest rate swaps. They allow two parties to exchange fixed and floating cash flows on an interest-bearing investment or loan.

Businesses or individuals take loans from the markets in which they have an advantage in order to secure a cost-effective loan. However, their selected market may not offer their preferred loan or loan structure. For instance, an investor may get cheaper loan in a floating rate market, but he prefers a fixed rate. Interest rate swaps enable the investor to switch the cash flows, as desired.

Assume Paul prefers fixed rate loans and has loans available at either floating rate (LIBOR+0.5%) or at fixed rate (10.75%). Mary prefers floating rate loan and has loans available at either floating rate (LIBOR+0.25%) or at fixed rate (10%). Due to her better credit rating with the lender, Mary has the advantage over Paul in both the floating rate market (by 0.25%) and in fixed rate (by 0.75%). Her advantage is greater in the fixed rate market, so she goes for fixed rate loan. However, since she prefers the floating rate, she gets into a swap contract with a bank to pay LIBOR and receive a 10% fixed rate.

Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into swap contract with the bank to pay fixed 10.10% and receive the floating rate. 

interest-rate-swap-working

Benefits: Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR from the bank. His net payment is 10.6% (fixed). The swap effectively converted his original floating payment to a fixed rate, getting him the most economical rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank, and receives 10% from the bank. Her net payment is LIBOR (floating). The swap effectively converted her original fixed payment to the desired floating, getting her the most economical rate. The bank takes a cut of 0.10% from what it receives from Paul and pays to Mary. (See related: How To Value Interest Rate Swaps.)

  • Currency Swaps

The transactional value of capital that changes hands in currency markets surpasses that of all other markets. Currency swaps offer efficient ways to hedge forex risk.

Assume an Australian company is setting up business in the UK and needs GBP 10 million. Assuming AUD/GBP exchange rate at 0.5, the total comes to AUD 20 million. Similarly, a UK-based company wants to setup a plant in Australia and needs AUD 20 million. The cost of a loan in the UK is 10% for foreigners and 6% for locals, while that in Australia is 9% for foreigners and 5% for locals. Apart from high cost of a loan for foreign companies, it might be difficult to easily get the loan due to procedural difficulties. Both companies have the competitive advantage in their domestic loan markets. The Australian firm can take a low-cost loan of AUD 20 million in Australia, while the English firm can take a loan of GBP 10 million in the UK. Assume both loans need six monthly repayments. Both companies can get into a currency swap agreement.

At the start, the Australian firm gives AUD 20 million to the English firm, and receives GBP 10 million, enabling both firms to start business in their respective foreign lands. Every six months, the Australian firm pays the English firm the interest payment for the English loan = (notional GBP amount * interest rate * period) = (10 million * 6% * 0.5) = GBP 300,000. While the English firm pays the Australian firm the interest payment for the Australian loan = (notional AUD amount * interest rate * period) = (20 million * 5% * 0.5) = AUD 500,000. Such interest payments continue until the end of the swap agreement, at which time, the original notional forex amounts will be exchanged back to each other.

Benefits: By getting into a swap, both firms were not only able to secure low-cost loans, but they also managed to hedge against interest rate fluctuations. Variations also exist in the currency swaps, including fixed v/s floating and floating v/s floating. Parties are able to hedge against volatility in forex rates, secure improved lending rates, and receive foreign capital.

  • Commodity Swaps

Commodity swaps are common among people or companies that use raw material to produce goods or finished products. Profit from a finished product may take a hit if the commodity prices vary, as output prices may not necessarily change in sync with the commodity prices. A commodity swap allows receipt of payment linked to the commodity price against a fixed rate.

Assume two parties get into a commodity swap over one million barrels of crude oil. One party agrees to make six-monthly payments at a fixed price of $60 per barrel and receive the existing (floating) price. The other party will receive the fixed and pay the floating.

Assume that price of oil shoots up to $62 at the end of six months, then the first party will be liable to pay the fixed ($60 *1 million) = $60 million, and receive the variable ($62 * 1 million) = $62 million from second. Net inflow will be $2 million from the second party to the first.

In case the price dips to $57 over next six months, the first party will pay net $3 million to the second party. 

Benefits: The first party has locked in the price of commodity using a currency swap, achieving a price hedge. Commodity swaps are effective hedging tools against variations in commodity prices or against variation in spreads between the final product and the raw material prices.

  • Credit Default Swaps (CDS)

Another popular type of swap, the credit default swap, offers insurance in case of default on part of a third-party borrower. Assume Peter bought a 15-year long bond issued by ABC, Inc. The bond is worth $1,000 and pays annual interest of $50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default, so he gets into a credit default swap contract with Paul. Under the swap agreement, Peter (CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc. and is ready to take the default risk on its behalf. For the $15 receipt per year, Paul will offer insurance to Peter for his investment and returns. In case ABC, Inc. defaults, Paul will pay Peter $1,000 plus any remaining interest payments. In case ABC, Inc. does not default throughout the 15-year long bond duration, Paul benefits by keeping the $15 per year without any payables to Peter.

Benefits: CDS work as insurance to protect the lenders and bondholders from borrowers’ default risk. (Related: Credit Default Swaps: An Introduction)

  • Zero Coupon Swaps (ZCS)

Similar to the interest rate swap, the zero coupon swap offers flexibility to one of the parties in the swap transaction. In a fixed-to-floating zero coupon swap, the fixed rate cash flows are not paid periodically, but only once at the end of the maturity of the swap contract. The other party paying floating rate keeps paying regular periodic payments following the standard swap payment schedule.

A fixed-fixed zero coupon swap is also available, wherein one party does not make any interim payments, but the other party keeps paying fixed payments as per the schedule.

Benefits: Such zero coupon swaps are primarily used for hedging. ZCS are often entered into by businesses to hedge a loan in which the interest is to be paid at maturity, or by banks that issue bonds with end-of-maturity interest payments.

  • Total Return Swaps (TRS)

A total return swap allows an investor all the benefits of owning a security, without actually owning it. A TRS is a contract between a total return payer and total return receiver. The payer usually pays the total return of an agreed security to the receiver, and receives a fixed/floating rate payment in exchange. The agreed (or referenced) security can be a bond, index, equity, loan, or commodity. The total return will include all generated income and capital appreciation.

Assume Paul (the payer) and Mary (the receiver) enter into a TRS agreement on a bond issued by ABC Inc. If ABC Inc.’s share price shoots up (capital appreciation) and it also pays a dividend (income generation) during the swap contract duration, then Paul will pay Mary all those benefits. In return, Mary will have to pay Paul a pre-determined fixed/floating rate during the duration of swap.

Benefits: Effectively, Mary receives total rate of return (in absolute terms) without actually owning the security. She has the advantage of leverage. Mary represents a hedge fund or a bank that benefits from the leverage and the additional income without owning the security.

Paul transfers both the credit risk and market risk to Mary, in exchange for a fixed/floating stream of payments. He represents a trader, whose long positions can be effectively converted to a short-hedged position, using a TRS. He can also defer the loss or gain to the end of swap maturity using a TRS.

The Bottom Line

Swap contracts, being OTC products, can be easily customized to meet the needs of all parties. They offer win-win situations for all parties, including intermediaries like banks that facilitate the transactions. Beyond the benefits, participants should also be aware of the pitfalls. Being bilateral agreements in OTC markets without regulations, an investor should understand a swap contract fully before entering into it.

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