In finance, a
swap is a
derivative in which two
counterparties exchange
certain benefits of one party's
financial instrument for those of the
other party's financial instrument. The benefits in question depend
on the type of financial instruments involved. Specifically, the
two counterparties agree to exchange one stream of
cash flows against another stream. These streams
are called the
legs of the swap. The swap agreement
defines the dates when the cash flows are to be paid and the way
they are calculated. Usually at the time when 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.
The cash flows are calculated over a
notional principal amount, which
is usually not exchanged between counterparties. Consequently,
swaps can be used to create unfunded exposures to an underlying
asset, since counterparties can earn the profit or loss from
movements in price without having to post the notional amount in
cash or
collateral.
Swaps can be used to
hedge certain
risks such as
interest rate risk,
or to
speculate on changes in the
expected direction of underlying prices.
The first swaps were negotiated in the early 1980s.
David Swensen, a Yale Ph.D. at Salomon
Brothers, engineered the first swap transaction according to
"
When
Genius Failed: The Rise and Fall of LongTerm Capital
Management" by
Roger
Lowenstein. Today, swaps are among the most heavily traded
financial contracts in the world.
Swap market
Most swaps are traded
overthecounter
(OTC), "tailormade" for the counterparties. Some types of swaps
are also exchanged on futures markets such as the Chicago
Mercantile Exchange Holdings Inc., the largest U.S. futures market,
the Chicago Board Options Exchange, IntercontinentalExchange and
Frankfurtbased Eurex AG.
The
Bank for International
Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC
derivatives market. At the
end of 2006, this was USD 415.2 trillion, more than 8.5 times the
2006 gross world product.
However, since the
cash flow generated by
a swap is equal to an interest rate times that notional amount, the
cash flow generated from swaps is a substantial fraction of but
much less than the gross world product—which is also a cashflow
measure. The majority of this (USD 292.0 trillion) was due to
interest rate swaps. These split
by currency as:
>

Notional outstanding
in USD trillion

Currency 
End 2000 
End 2001 
End 2002 
End 2003 
End 2004 
End 2005 
End 2006 
Euro 
16.6 
20.9 
31.5 
44.7 
59.3 
81.4 
112.1 
US dollar 
13.0 
18.9 
23.7 
33.4 
44.8 
74.4 
97.6 
Japanese yen 
11.1 
10.1 
12.8 
17.4 
21.5 
25.6 
38.0 
Pound sterling 
4.0 
5.0 
6.2 
7.9 
11.6 
15.1 
22.3 
Swiss franc 
1.1 
1.2 
1.5 
2.0 
2.7 
3.3 
3.5 
Total 
48.8 
58.9 
79.2 
111.2 
147.4 
212.0 
292.0 
 Source: "The Global OTC Derivatives Market at
endDecember 2004", BIS, [57480], "OTC Derivatives Market Activity in the
Second Half of 2006", BIS, [57481]
Usually, at least one of the legs has a rate that is
variable. It can depend on a reference rate, the total
return of a swap, an economic statistic, etc. The most important
criterion is that it comes from an independent third party, to
avoid any
conflict of interest.
For instance,
LIBOR is published by the
British Bankers
Association, an independent trade body.
Types of swaps
The five generic types of swaps, in order of their quantitative
importance, are:
interest rate
swaps, currency swaps, credit swaps,
commodity swaps and
equity swaps. There are also many other
types.
Interest rate swaps
A is currently paying floating, but wants to pay fixed.
B is currently paying fixed but wants to pay floating.
By entering into an interest rate swap, the net result is that
each party can 'swap' their existing obligation for their desired
obligation.
Normally the parties do not swap payments directly, but
rather, each sets up a separate swap with a financial intermediary
such as a bank.
In return for matching the two parties together, the bank
takes a spread from the swap payments.
The most common type of swap is a “plain Vanilla” interest rate
swap. It is the exchange of a fixed rate loan to a floating rate
loan. The life of the swap can range from 2 years to over 15
years.The reason for this exchange is to take benefit from
comparative advantage. Some companies
may have comparative advantage in fixed rate markets while other
companies have a comparative advantage in floating rate markets.
When companies want to borrow they look for cheap borrowing i.e.
from the market where they have comparative advantage. However this
may lead to a company borrowing fixed when it wants floating or
borrowing floating when it wants fixed. This is where a swap comes
in. A swap has the effect of transforming a fixed rate loan into a
floating rate loan or vice versa.
For example, party B makes periodic interest payments to party A
based on a
variable interest rate of
LIBOR +70
basis points.
Party A in turn makes periodic interest payments based on a fixed
rate of 8.65%. The payments are calculated over the
notional amount. The first rate is called
variable, because it is reset at the beginning of each
interest calculation period to the then current
reference rate, such as
LIBOR. In reality, the actual rate received by A and B
is slightly lower due to a bank taking a spread.
Currency swaps
A currency swap involves exchanging principal and fixed rate
interest payments on a loan in one currency for principal and fixed
rate interest payments on an equal loan in another currency.Just
like interest rate swaps, the currency swaps also are motivated by
comparative advantage.
Commodity swaps
A commodity swap is an agreement whereby a floating (or market or
spot) price is exchanged for a fixed price over a specified period.
The vast majority of commodity swaps involve oil.
Equity Swap
An equity swap is a special type of total return swap, where the
underlying asset is a stock, a basket of stocks, or a stock index.
Compared to actually owning the stock, in this case you do not have
to pay anything up front, but you do not have any voting or other
rights that stock holders do have.
Credit default swaps
A credit default swap (CDS) is a swap contract in which the
buyer of the CDS makes a series of payments to the
seller and, in exchange, receives a payoff if a credit
instrument  typically a
bond or
loan  goes into
default (fails to pay). Less commonly, the
credit event that triggers the payoff
can be a company undergoing
restructuring,
bankruptcy or even just having its credit rating
downgraded. CDS contracts have been compared with
insurance, because the
buyer
pays a
premium and, in return, receives a
sum of
money if one of the events specified in
the contract occur
Other variations
There are myriad different variations on the vanilla swap
structure, which are limited only by the imagination of financial
engineers and the desire of corporate treasurers and fund managers
for exotic structures.
 A total return
swap is a swap in which party A pays the total
return of an asset, and party B makes
periodic interest payments. The total return is the capital gain or
loss, plus any interest or dividend payments. Note that if the
total return is negative, then party A receives this amount from
party B. The parties have exposure to the return of the underlying
stock or index, without having to hold the underlying assets. The profit or loss of party B
is the same for him as actually owning the underlying asset.
 An option on a swap is called a
swaption. These provide
one party with the right but not the obligation at a future time to
enter into a swap.
 A variance swap
is an overthecounter instrument that allows one to speculate on
or hedge risks associated with the magnitude of movement, i.e.
volatility, of some underlying
product, like an exchange rate, interest rate, or stock index.
 A constant maturity
swap, also known as a CMS, is a
swap that allows the purchaser to fix
the duration of received flows on a
swap.
 An Amortising
swap is usually an interest rate swap in which the notional
principal for the interest payments declines during the life of the
swap, perhaps at a rate tied to the prepayment of a mortgage or to
an interest rate benchmark such LIBOR.
Valuation
The value of a swap is the
net present
value (NPV) of all estimated future cash flows. A swap is worth
zero when it is first initiated, however after this time its value
may become positive or negative. There are two ways to value swaps:
in terms of
bond prices, or as a portfolio of
forward contracts.
Using bond prices
While principal payments are not exchanged in an interest rate
swap, assuming that these are received and paid at the end of the
swap does not change its value. Thus, from the point of view of the
floatingrate payer, a swap can be regarded as a long position in a
fixedrate bond (i.e.
receiving fixed interest payments), and a short position
in a
floating rate note (i.e.
making floating interest payments):
 V_{swap} = B_{fixed}  B_{floating}
From the point of view of the fixedrate payer, the swap can be
viewed as having the opposite positions. That is,
 V_{swap} = B_{floating}  B_{fixed}
Similarly, currency swaps can be regarded as having positions in
bonds whose cash flows correspond to those in the swap. Thus, the
home currency value is:
 V_{swap} = B_{domestic}  S_{0}B_{foreign}, where B_{domestic}
is the domestic cash flows of the swap, B_{foreign} is the foreign
cash flows of the swap, and S_{0} is the spot exchange rate.
Using forward rate agreements
Consider a three year interest rate swap with
semiannual payments. The first cash flow is known
at the time the swap is initiated, however the other five exchanges
can be regarded as forward rate agreements. The payment for these
other exchanges is the 6 month rate observed in the market 6 months
earlier. Assuming that forward interest rates are realised, this
method values the swap by firstly calculating the required forward
rates using the
LIBOR/swap curve, then
calculating the swap cash flows using these rates, and then finally
discounting these cash flows back to today.
London Interbank Offered Rate (LIBOR)
LIBOR is the rate of interest offered by banks on deposit from
other banks in the
eurocurrency market.
Onemonth LIBOR is the rate offered for 1month deposits, 3month
LIBOR for three months deposits, etc.LIBOR rates are determined by
trading between banks and change continuously as economic
conditions change. Just like the prime rate of interest quoted in
the domestic market, LIBOR is a reference rate of interest in the
International Market.
Arbitrage arguments
As mentioned, to be arbitrage free, the terms of a swap contract
are such that, initially, the NPV of these future cash flows is
equal to zero. Where this is not the case, arbitrage would be
possible.
For example, consider a plain vanilla fixedtofloating interest
rate swap where Party A pays a fixed rate, and Party B pays a
floating rate. In such an agreement the
fixed rate would
be such that the present value of future fixed rate payments by
Party A are equal to the present value of the
expected
future floating rate payments (i.e. the NPV is zero). Where this is
not the case, an
Arbitrageur, C, could:
 assume the position with the lower present value of
payments, and borrow funds equal to this present value
 meet the cash flow obligations on the position by using the
borrowed funds, and receive the corresponding payments  which have
a higher present value
 use the received payments to repay the debt on the borrowed
funds
 pocket the difference  where the difference between the
present value of the loan and the present value of the inflows is
the arbitrage profit.
Subsequently, once traded, the price of the Swap must equate to the
price of the various corresponding instruments as mentioned above.
Where this is not true, an arbitrageur could similarly
short sell the overpriced instrument, and use the
proceeds to purchase the correctly priced instrument, pocket the
difference, and then use payments generated to service the
instrument which he is short.
See also
References
 Financial Institutions Management, Saunders A. & Cornett
M., McGrawHill Irwin 2006
 John C Hull, Options, Futures and Other Derivatives (6th
edition), New Jersey: Prentice Hall, 2006, 149
 p160
 p163
External links