What is Swaps Derivatives? Understand Here!

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What is a Swap?

When it comes to the exchange of cash flows, there are many traditional methods that are available in the market. These exchanges required the finances of the sender as well as the to be of the same financial instrument, To combat this challenge, swaps derivatives were introduced. It is a recent trend in this space. A swap is essentially a derivative contract with the help of which two parties can exchange either liabilities or cash flows from two completely different financial instruments. Most swaps derivatives don’t necessarily involve cash flows that are based on a principal amount that could be a bond or a loan. The instrument can be almost anything. Usually, there is no transfer of the principal amount involved.

One cash flow is usually fixed and the other cash flow is maintained to be variable. This variable aspect is based on the benchmark interest rate, index price, or the floating currency exchange rate. Each of these cash flows comprises one leg of the swap.

The most common type of swaps derivatives is the interest rate swap. Usually, swaps are not traded on exchanges. As a result, retail investors don’t usually engage in swaps. Instead, swaps are usually exchanged between businesses or financial institutions as they are considered to be over-the-counter contracts. Usually, these swaps are customized to the needs of both parties.

Different Types of Swaps

There are 6 different types of swaps that are available in the market. Let us have a look at each of them.

1. Interest Rate Swaps

With respect to an interest rate swap, the main aspect is that the parties involved in this swaps derivatives exchange cash flows on a principal amount. This is done to hedge against the risk associated with the interest rate or to even speculate. For instance, assume that a certain business had issued a certain amount of money in three-year bonds with an annual interest that is variable. This varying interest rate causes a certain level of anxiety for the business especially with regards to a rise in the rate of interest.

In response, the management team of this company finds another company that is willing to pay a fixed interest rate, although it may not be as high or rewarding. In simple terms, the new company will pay the interest rate for the three-year bond offered by the other company. In this case, the company issuing the bonds will benefit greatly from the swap if the rates rise significantly over the next three years. We will read more about this in later sections of this article.

2. Debt-Equity Swaps

With a debt-equity swap, the primary function is that it involves the exchange of equity or debt. This happens in the case of a publicly traded6 company. This way, bonds would be purchased synonymous with stocks. This is a means for companies to re-allocate their capital structure and also to refinance their debt.

3. Credit Default Swaps

The main aspect of a credit default swap is that it consists of an agreement by one party to pay for the principal that is lost and the interest of a loan to the buyer of the credit default swap in case a borrower defaults on a loan. A combination of poor risk management along with excessive leverage in the credit default swap market was a combining cause for the financial crisis that occurred in 2008.

4. Currency Swaps

In a currency swap, both the interest as well as the principal payments are exchanged on the debt that is denominated in different currencies. This is different from an interest rate swap as a principal swap is not a notional amount, Rather, it is exchanged along with certain interest obligations. Currency swaps also have the option to take place between countries.

5. Commodity Swaps

This type of swap involves the exchange of a floating commodity price for a certain set price over a period of time that is previously agreed upon. Usually, commodity swaps largely involve crude oil.

6. Total Return Swaps

When it comes to a total return swap, the total return from an asset is usually exchanged at a pre-determined and fixed interest rate. This way, the party pays a certain fixed-rate exposure to an underlying asset that is most commonly an index or a stock. For instance, a particular investor can pay a fixed rate to any one party in return for capital appreciation along with the dividend payments of a series of stocks.

What is the Swap Curve?

The swap curve is a plot that represents the rates across all the available maturities. As the swap rates typically incorporate a large overview of the forward expectations for LIBOR and the perception of the market on other factors such as credit quality of banks, liquidity, supply and demand dynamics, etc., the swap curve is crucial when it comes to understanding the interest rate benchmark. While the swap curve can be similar in shape to the sovereign yield curve, swaps can usually trade either lower or even higher than sovereign yields. The primary difference between the two is the swap spread.

What are the Risks Involved With Swaps Derivatives?

Similar to most of the fixed-income investments associated with non-governmental bodies or associations, interest rate swaps have their risks too. There are two common risks associated with interest rate swaps namely credit risk and interest rate risk. As the interest rate movements don’t necessarily match the expectations these swaps are prone to risks associated with interest rates. In simple terms, the receiver will profit if there is a fall in the interest rate. In contrast, the payer will profit if there is a rise or increase in the interest rate.

Swaps are also prone to the credit risk of the counterparty. This happens given the chance that the other party in the contract tends to default on their responsibility. Since the financial crisis, this risk has been mitigated to an extent.

In a Nutshell

There are several different types of swaps derivatives that can help with cash flow and allow them to not be associated with a certain principal amount. Usually, the principal amount is not exchanged. Such types of exchanges are commonly carried out with businesses, institutions, and financial entities.

What are Interest Rate Swaps

Before we dive into what interest rate swaps are, we must first visit that interest rate mentioned earlier. Interest rates come in two forms, and understanding how the two types of interest rates function are essential to understanding not only how an interest rate swap works, but also why companies would want to deal in interest rate swaps in the first place.

Fixed Interest Rate vs Floating Interest Rate

This concept is fairly simple to grasp, yet plays an essential role in the understanding of interest rate swaps. It will also be useful for the interest rate swap example we have planned.

Fixed Interest Rate: A fixed interest rate implies that the borrower will pay a fixed sum for every period (monthly, annually etc), until the loan lapses. If for instance, you borrow USD 1 Million at a fixed interest rate of 8%, you will have to pay USD 80,000 every year, until the loan period ends.

Floating Interest Rate: As the name suggests, a floating interest rate is not constant, and usually varies based on the value of an underlying benchmark index. Labour is a common benchmark index( LIBOR or the London Interbank Offered Rate, is an interest rate average that is calculated based on estimates submitted by a slew of top banks in London. Labour is simply a popular example, and the interest rate terms can theoretically be based on any underlying benchmark index of choice, provided both parties agree to it, as do regulators). If you were to borrow the same USD 1 million, with a floating exchange rate you would pay interest based on certain terms. For instance, if Libor is 5%, the terms of the loan would dictate you pay Libor + 2%, or USD  70,000. If in the second period Libor is at 4%, you might pay Libor + 2%, or usd 60,000. These numbers will be useful for our example.

How Interest rate swaps work

Cutting through the jargon, an interest rate swap takes place when two entities are not happy with their current interest payment setup and wish to switch from a floating to fixed interest rate, or vice versa, in hopes that the market will move in their favour.

Let’s say company A borrows USD 1 million dollars from Lender A, at a floating interest rate of Libor + 2%. This means that if in Period 1 Libor was 5%, Company A pays 5% + 2%, or USD 70,000 dollars on the million-dollar loan. If Libor is at 4% the next period, this moves to USD 60,000 accordingly.

Company B takes out a loan from Lender B at a fixed interest rate of 8%. Meaning for period 1 and 2, they will pay 8% or 80,000 dollars. For the sake of this example, let’s assume that both Company A and B wish to swap their interest rate payments. This is how they would go about it.

As per the terms of their Interest rate swap agreement, Company A agrees to pay Company B 7% (of the notional one million) per period. In return, Company B will pay Company A Libor + 1% per period.

Period Company A Company B
1 (With Libor at 5%) Pays –70,000 dollars to B Pays Libor + 1% (-60,000) to Company A
Pays Libor + 2% (-70,000)  to Lender A Pays -80,000 dollars to Lender B
Gets Libor + 1% (+60,000) from Company B Gets +70,000 from Company A.
Total Interest Paid for Period 1 80,000 70,000
   
2 (With Libor at 4%)

 

 

 

Pays -70,000 dollars to Company B Pays Libor + 1% (-50,000) to company A
Pays Libor + 2% (-60,000) to Lender A Pays -80,000 dollars to Lender B
Gets Libor + 1% (+50,000 dollars) from company B Gets +70,000 dollars from company A.
Total Interest Paid for Period 1 80,000 60,000

*ALL values are positive. The “-” and “+” signs signify credit (+) and debit (-) moves.

As you can see on the chart (look at the Total Interest Paid by both companies for both periods), the interest rate swaps have resulted in company A now having a fixed interest rate payment, while company B which had the fixed interest payment, now has a floating interest rate setup. The swap has granted both entities their desired debt repayment structures.

Things to keep in mind

The keen-eyed among you might have noticed us mention that the payment in the example was offered on the “notional” one million. This is because, in an interest rate swap, no debt actually exchanges hands, simply the difference between the debt payment does. In the example mentioned above, neither company takes on the responsibility of each other’s debt or the debt amount. They simply enter into an agreement that is tethered to their individual loan agreements, resulting in them being able to switch their repayment structures.

Additionally, in this setup, one company stands to win while the other stands to lose; there can be only one winner. If Libor goes up, company B might have the raw end of the deal. If it goes down, however, it gets to make lower debt payments. Lastly, interest rate swaps cannot be traded on any official stock exchange, they exist exclusively in the OTC (over-the-counter) markets.