Though swaps and the swap market are mysterious to typical individual investors and casual market followers, they nonetheless play an important role in the global economy. This article takes a closer look at swaps and the swap market, to demystify this often confusing and misunderstood subject.

Introduction to Swaps

A swap is a derivative instrument allowing counterparties to exchange (or "swap") a series of cash flows based on a specified time horizon. Typically, one series of cash flows is considered the “fixed leg” of the agreement, while the less predictable “floating leg” includes cash flows based on interest rate benchmarks or foreign exchange rates. The swap contract, which is agreed on by both parties, specifies the terms of the swap, including the underlying values of the legs, plus payment frequency and dates. People typically enter swaps either to hedge against other positions or to speculate on the future value of the floating leg's underlying index/currency/etc.

For speculators like hedge fund managers looking to place bets on the direction of interest rates, interest rate swaps are an ideal instrument. While one traditionally trades bonds to make such bets, entering into either side of an interest rate swap agreement gives immediate exposure to interest rate movements with virtually no initial cash outlay.

Counterparty risk is a major consideration for swap investors. 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. A counterparty’s failure to meet their obligation could make it difficult for swap investors to collect rightful payments.

The Swap Market

Since swaps are highly customized and not easily standardized, the swap market is considered an over-the-counter market, meaning that swap contracts cannot typically be easily traded on an exchange. But that does not mean swaps are illiquid instruments. In fact, the swap market is one of the largest and most liquid global marketplaces, with many willing participants eager to take either side of a contract. According to the most recent statistics, the notional amount outstanding in over-the-counter interest rate swaps was more than $542 trillion.

Types of Swaps

1) Plain Vanilla Swaps

Plain vanilla interest rate swaps are the most common swap instrument. They are widely used by governments, corporations, institutional investors, hedge funds and numerous other financial entities.

In a plain vanilla swap, Party X agrees to pay Party Y a fixed amount based upon a fixed interest rate and a notional dollar amount. In exchange, Party Y will pay Party X an amount based upon that same notional amount as well as a floating interest rate, typically based upon LIBOR.

The notional amount, however, is never exchanged between parties, as the next effect would be equal. At the start, the value of the swap to either party is zero. However, as interest rates fluctuate, the value of the swap fluctuates as well, 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.

Take the following scenario: Party X had agrees to pay a fixed rate of 4% while receiving a floating rate of LIBOR+50 bps from 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.

2) Currency Swap

In a currency swap, two counterparties aim to exchange principal amounts and pay interest in their respective currencies. Such swap agreements let the counterparties gain both interest rate exposure and foreign exchange exposure, as all payments are made in the counterparty's currency.

For example, say 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 expected to close in the U.S. 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 forces both sides to exchange payments based upon fluctuations in both domestic rates and the exchange rate between the U.S. dollar and the British pound over the life of the agreement (see also: Currency Swap Basics).

3) Equity Swap

An equity swap is similar to an interest rate swap, but rather than one leg being the "fixed" side, it is based on 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 (see also: 5 Equity Derivatives and How They Work).

4) Credit Default Swaps

A credit default swap, or CDS, acts differently than other types of swaps. A CDS can be viewed almost as a type of insurance policy, by which the purchaser makes 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 premiums, are based upon the default swap spread for the underlying security (also referred to as the default swap premium).

Say a portfolio manager holds a $1 million bond (par value) and wishes 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, $500,000. (See also: Credit Default Swaps: An Introduction.)

The Bottom Line

Swap agreements and the swap market can be easy to understand once you know the fundamentals. Swaps are a popular derivative instrument utilized by parties of all types to meet their specific investment strategies.

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