swaps contracts

• Swaps contracts


  Arrangements between two counterparts to exchange cash flows over time. The arrangement defines the dates when the cash flows are to be paid and the way in which they are to be calculated

  
• Swaps contracts are traded over-the-counter
• The first swap contracts were negotiated (a currency swap negotiated between IBM and the World Bank in 1981)


  Early 1980s
• Most common types of swaps


  • Plain vanilla interest rate swaps
  • Fixed-for-fixed currency swaps
• Over-the-counter derivative: "plain vanilla" interest rate swap


  A company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time
• The principal is used only for the calculation of interest payments. The principal itself is not exchanged. This is why it is termed the notional principal
• Following the credit crisis of 2008


  • There was an international agreement that standard swaps, where appropriate, be traded on electronic platforms and cleared through central counterparties (CCPs)
  • In the United States, there is now a rule requiring that standard swap transactions between financial institutions be executed on electronic platforms, known as swap execution facilities, and be cleared through a CCP
  • This rule does not apply when one of the parties to a swap agreement is an end user, whose main activity is not financial and who is using swaps to hedge or mitigate commercial risk

  
• Occasionally, a financial institution may be lucky enough to enter into offsetting trades with two different nonfinancial companies at about the same time. Usually, however, when it enters into a trade with only one company, it must manage its risk by entering into the opposite trade with another financial institution
• Fixed-for-fixed currency swap


  This involves exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency
• A currency swap agreement requires the principal to be specified in each of the two currencies
• The principal amounts in each currency are usually exchanged at the beginning and at the end of the life of the swap
• The principal amounts are chosen to be approximately equivalent using the exchange rate at the swap's initiation, but when they are exchanged at the end of the life of the swap, their values may be quite different

  
• Fixed-for-fixed currency swap


  The interest rate in both currencies is fixed

  
• Fixed-for-fixed currency swap


  1. Initially, the principal amounts flow in the opposite direction to the arrows. At the outset of the swap, British Petroleum pays £10 million and receives $15 million

  2. The interest payments during the life of the swap and the final principal payment flow in the same direction as the arrows

  3. Each year during the life of the swap contract, British Petroleum receives £0.40 million (=4% of £10 million) and pays $0.45 million (=3% of $15 million)

  4. At the end of the life of the swap, it pays $15 million and receives £10 million

  
• Use of a currency swap to transform liabilities and assets


  • A swap can be used to transform borrowings in one currency to borrowings in another currency
  • A swap can also be used to transform the nature of assets
• The swap can have the effect of transforming a loan or investment from one currency to another
• Comparative advantage


  Motivation for currency swaps. Parties can borrow in the market where they have an advantage and then use a swap to transform the loan into the desired currency
• The total gain to all parties in a currency swap is the difference between the spreads in the two currency markets

  
• Valuation of fixed-for-fixed currency swaps


  The value of the swap is the difference between the value of the bond defined by the foreign cash flows and the value of the bond defined by the domestic cash flows, adjusted for the spot exchange rate

  
• Other types of currency swaps


  • Fixed-for-floating
  • Floating-for-floating
• Fixed-for-floating currency swap


  A floating interest rate in one currency is exchanged for a fixed interest rate in another currency
• Floating-for-floating currency swap


  A floating interest rate in one currency is exchanged for a floating interest rate in another currency
• Credit default swap (CDS)


  A swap that allows companies to hedge credit risks. It is like an insurance contract that pays off if a particular company or country defaults
• The buyer of credit protection pays an insurance premium, known as the CDS spread, to the seller of protection for the life of the contract or until the reference entity defaults
• If the reference entity does not default during the contract, nothing is received in return for the insurance premiums. If the reference entity does default, the seller of protection has to make a payment to the buyer of protection
• Other types of swaps


  • Equity swaps
  • Swaps with embedded options (extendable, puttable)
• Equity swap


  An agreement to exchange the total return (dividends and capital gains) realized on an equity index for either a fixed or a floating rate of interest
• Swaps with embedded options


  Extendable swap: one party has the option to extend the life of the swap

  Puttable swap: one party has the option to terminate the swap early