Derivatives contracts can be divided into two general families:
1. Contingent claims, e.g. options
2. Forward claims, which include exchange-traded futures, forward contracts, and swaps
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.
The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.
The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market.
Credit Default Swaps (CDS)
Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the times between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
For example, on Dec. 31, 2006, Company A and Company B enter into a five-year swap with the following terms:
- Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
- Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the Eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example).
Figure 1: Cash flows for a plain vanilla interest rate swap
Plain Vanilla Foreign Currency Swap
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.
For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (e.g. the dollar is worth 0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million euros. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).
Figure 2: Cash flows for a plain vanilla currency swap, Step 1
As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If at the one-year mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D.
Company D will pay Company C $50,000,000 * 8.25% = $4,125,000.
Figure 3: Cash flows for a plain vanilla currency swap, Step 2
Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.
Figure 4: Cash flows for a plain vanilla currency swap, Step 3
Who Would Use a Swap?
The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.
Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing.
For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By using a currency swap, the firm ends up with the euros it needs to fund its expansion.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling exchange-traded futures or options contracts before expiration. There are four basic ways to do this:
1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.
2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty.
4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.
The Bottom Line
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.