Derivatives and Swaps
A derivative is a contract between two or more parties whose value is based upon underlying financial assets or security. Some of the underlying assets include bonds, commodities, currencies, interest rates, market indexes and stocks. Common examples of derivatives include swaps, future contracts, forward contracts, options and warrants. Derivatives are used for speculating and hedging purposes.
A swap therefore is an agreement between two parties (called counterparties) to exchange series of payments made periodically on settlement days over a certain period of time. The amounts of the payments exchanged is based on some predetermined principal, called the notional principal amount. Swaps are traded over-the-counter; trade conducted through a dealer network as opposed to through a centralized exchange. Swap transactions between two counterparties are made successful through swap dealers; an individual who acts as the counterparty in a swap agreement for a fee called a spread. Swap dealers are the market makers for the swap market. The spread represents the difference between the wholesale price for trades and the retail price.
FEATURES OF SWAPS
- Swaps are done on large institutions.
- Most involve multiple payments, although one-payment contracts are possible
- A series of forward contracts.
- When initiated, neither party exchanges any cash; a swap has zero value at the beginning.
- One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that both parties pay each other on the movement of an underlying asset.
- Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other. This is called netting.
- Final payment is made on the termination date.
- Usually traded in the over-the-counter market. This means they are subject credit risk
TYPES OF SWAPS
There are a wide variety of swaps that financial professionals trade in order to hedge against risk. Listed below are a few most common types of swap instruments traded in the market.
Interest Rate Swap
An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the conditions and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and basis for the floating index.
An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a basis swap). In brief, an interest rate swap is priced by first present valuing each leg of the swap (using the appropriate interest rate curve) and then aggregating the two results.
A currency swap is a foreign exchange agreement between two institutes to exchange principal and interest payments of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. They are used to secure cheaper debt by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency. They are also used to hedge against exchange rate fluctuations. They are used to convert an asset/liability in one currency into the respective asset/liability in another currency.
A commodity swap is a swap in which one of the payment streams for a commodity is fixed and the other is floating. Usually only the payment streams, not the principal, are exchanged, although physical delivery is becoming increasingly common. Commodity swaps have been in existence since the mid-1970’s and enable producers and consumers to hedge commodity prices. Usually, the consumer would be a fixed payer to hedge against rising input prices. The producer in this case pays floating (i.e., receiving fixed for the product) thereby hedging against falls in the price of the commodity. If the floating-rate price of the commodity is higher than the fixed price, the difference is paid by the floating payer, and vice versa.
Credit Default Swap
A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event. A credit event is usually a default or, possibly, a credit downgrade of the entity. The reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. The buyer of a default swap pays a premium to the writer or seller in exchange for right to receive a payment should a credit event occur. In essence, the buyer is purchasing insurance.
An asset swap is a combination of a default able bond with a fixed-for-floating interest rate swap that swaps the coupon of the bond into the cash flows of LIBOR plus a spread. In the case of a cross currency asset swap, the principal cash flow may also be swapped. In a typical asset swap, a dealer buys a bond from a customer at the market price and sells to the customer a floating rate note at par. The dealer then enters into a fixed-for-floating swap with another counterparty to offset the floating rate obligation and the bond cash flows. For a premium bond, the dealer pays the customer the difference of the bond price and its par. For a discount bond, the customer pays the dealer the difference of the par and the bond price. In the swap with the counterparty, the dealer pays a fixed bond coupon and receives LIBOR + a spread. The spread can be determined from the cash that the dealer pays/receives and from the difference of the bond coupon and the par swap rate. When the bond redemption value is used for exchange of principal at maturity, the present value of the difference between the bond redemption value and its par value also contributes to the spread.
A Trigger Swap is an interest rate swap in which payments are knocked out if the reference rate is above a given trigger rate. FINCAD provides analytics for two types of trigger swaps: periodic and permanent. For a periodic trigger swap, the exchange of payments depends on the reference rate set for that period. If the reference rate for a particular period is greater than the trigger rate, the fixed and floating payments are knocked out. If the reference rate is below the trigger rate in a subsequent period, regular fixed and floating payments are made. For a permanent trigger swap, if the fixed and floating payments are knocked out for a particular period, then all subsequent payments are knocked out as well.
Foreign-Exchange (FX) Swaps
An FX swap is where one leg’s cash flows are paid in one currency, while the other leg’s cash flows are paid in another currency. An FX swap can be either fixed for floating, floating for floating, or fixed for fixed. In order to price an FX swap, first each leg is present valued in its currency (using the appropriate curve for the currency).
Total Return Swap
A total return swap (TRS) is a bilateral financial contract in that one counterparty pays out the total return of a specified asset, including any interest payment and capital appreciation or depreciation, in return receives a regular fixed or floating cash flow. Typical reference assets of total return swaps are corporate bonds, loans and equities. A total return swap can be settled at the terminating date only or periodically, e.g., quarterly. For convenience we call the asset’s total return a TR-leg and the fixed or floating cash flow a non-TR leg.
Accreting Principal Swaps
An accreting principal swap, is an interest rate or cross-currency swap where the notional principal grows as it reaches maturity. This type of swap may be used in instances where the borrower anticipates the need to draw down funds over a certain period of time but wants to fix the cost of the funds in advance.
Bond Market Association Swaps
A type of swap arrangement in which two parties agree to exchange interest rates on debt obligations, where the floating rate is based on the bond market association’s swap index. One of the parties involved will swap a fixed interest rate for a floating rate, while the other party will swap a floating rate for a fixed rate.
BENEFITS OF USING SWAPS
Unlike interest rate swaps, which allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum, currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. They also provide a chance to exploit advantages across a network of currencies and maturities. The success of the currency swap market and the success of the Eurobond market are explicitly linked.
Currency swaps generate a larger credit exposure than interest rate swaps because of the exchange and re-exchange of notional principal amounts. Companies have to come up with the funds to deliver the notional at the end of the contract, and are obliged to exchange one currency’s notional against the other at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain. This potential exposure is magnified as volatility increases with time. The longer the contract, the more room for the currency to move to one side or the other of the agreed upon contracted rate of principal exchange. This explains why currency swaps tie up greater credit lines than regular interest rate swaps.
Currency swaps are priced or valued in the same way as interest rate swaps – using a discounted cash flow analysis having obtained the zero coupon version of the swap curves. Generally, a currency swap transacts at inception with no net value. Over the life of the instrument, the currency swap can go “in-the-money,” “out-of-the-money” or it can stay “at-the-money.”
Terminating a Swap Contract
The easiest way to terminate the contract is to hold it to maturity. However, if one or both parties in a swap contract wish to terminate, there are several methods:
- Enter into a separate and offsetting swap. For example, an entity has a swap on its books that pays a fixed rate and receives a floating rate based on LIBOR on January 1 and July 1. The entity can enter into a new swap that pays a floating rate based on LIBOR and receives a fixed rate with payments on January 1 and July 1. With this new transaction, your fixed rates may be different because of market rates, while the LIBOR payments will wash out over the transaction’s life. Credit risk will also increase because you could have a new counterparty for the new swap.
- The other way is to have a cash settlement based on market value. For example, assume that a party holds a swap with a market value of $65,000. The contract could be terminated if the other party pays the market value of the contract to the holder. Said another way, if the party holding the swap has a negative value, it can terminate the swap by paying its counterparty the market value of the swap. This terminates the contract for both parties, but this is usually available only if it is stated before the contract is entered into or agree upon by both parties at a later date.
- Another way to terminate a swap is to sell the swap to another party. This usually requires permission from the other party. This is not commonly used in the market place.
- The last way to terminate a contract is to use a swaption. A swaption works like an option by giving the owner the right to enter into another swap at terms that are set in advance. By executing the swaption, the party can offset its current swap as explained in the first way to terminate a contract