WHAT IS 'Price Swap Derivative'

A price swap derivative is a derivative transaction where one entity guarantees a fixed value for the total asset holdings of another entity over a specified period. Under this type of agreement, whenever the value of the secured assets declines, the counterparty must deliver stock or other collateral to offset that loss and bring the asset back to its original value.

BREAKING DOWN 'Price Swap Derivative'

Price swap derivatives enable the value of one company’s assets to stay constant over a set period, through the help of another company’s distributing shares. In this sense, the price swap derivative can effectively hide the fact that the receiving company’s financial position is weakening over time. However, when the counterparty issues new shares to fill the gap created by the lowered asset, it results in dilution of value for existing shareholders. This combination of a misleading valuation on one side and increasingly diluted stock on the other can destabilize the financial standing of both parties in the agreement. 

Price swap derivatives today are relatively unusual transactions. Their rareness is due to changes in accounting rules and the availability of more common methods to insure against declines in asset values. 

Under a more common form of derivative known as a futures contract, one party agrees to sell an asset to another party at a preset price on a predetermined future date. Options are a derivative similar to futures, with the chief difference being that the buyer is not required to purchase assets when the future date arrives.

Example of Price Swap Derivative

Price swap derivatives were made famous by the Enron financial scandal. Enron used price swap derivatives to guarantee the value of one of its subsidiaries, a limited partnership named Raptor. Under the derivative transaction, whenever Raptor’s assets fell below $1.2 billion, Enron promised to give enough stock to the subsidiary to make up the difference and keep Raptor assets at a constant.

As this repeatedly happened over time, Enron stock made up an increasing portion of Raptor’s total assets. This practice only increased the need to trigger transactions, since whenever Enron’s stock fell, it would also bring Raptor assets below the $1.2 threshold. This downward spiral continued to force Enron to issue additional shares to the subsidiary. While the accelerating derivative transactions diluted stock values for Enron shareholders, they also prevented the company from having to record the plummeting value of the subsidiary, resulting in helping to inflate its bottom line on regular financial statements.

RELATED TERMS
  1. Inflation Derivatives

    Inflation derivatives are derivative used by investors to hedge ...
  2. Credit Derivative

    A credit derivative is a financial asset in the form of a privately ...
  3. Stock Swap

    A stock swap is the exchange of one equity-based asset for another. ...
  4. Swap Curve

    A swap curve identifies the relationship between swap rates at ...
  5. Total Return Swap

    In a total return swap, one party makes payments based on a set ...
  6. Accreting Principal Swap

    An accreting principal swap is a derivative contract that features ...
Related Articles
  1. Trading

    Derivatives 101

    Learn how to use derivatives to hedge, speculate or increase leverage in an investment portfolio.
  2. Small Business

    Why Enron Collapsed

    Enron’s collapse is a classic example of greed gone wrong.
  3. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  4. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  5. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  6. Financial Advisor

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
  7. Retirement

    Business Owners: Avoid Enron-esque Retirement Plans

    If your business administers a retirement plan, you should recognize what's at stake.
  8. Investing

    Buffett Nixes Credit Derivatives From Berkshire Portfolio

    After years of gradually reducing exposure to credit derivatives, Buffett's Berkshire Hathaway finally exits the market completely.
  9. Investing

    Did Derivatives Cause The Recession?

    We may never come to a consensus on what caused the financial collapse, but derivatives definitely share a large part of the blame.
  10. Trading

    Examples Of Exchange-Traded Derivatives

    We look at some of the most common exchange-traded derivatives.
RELATED FAQS
  1. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  2. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  3. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  4. Are ETFs considered derivatives?

    Learn why most exchange-traded funds (ETFs) are not considered derivative securities and the special circumstances when this ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center