Swap (finance)

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For the Thoroughbred horse racing champion, see: Swaps (horse).

In finance, a swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The cash flows are calculated over a notional principal amount. Swaps are often used to hedge certain risks, for instance interest rate risk. Another use is speculation.

An illustration of a standard fixed/float interest rate swap

1 Structure
2 Interest Rate Swap
3 Total return swap
4 Equity Swap
5 Valuation
6 Variations
7 Options
8 See also
9 External links

[edit] Structure

Example

For example, take the case of a plain vanilla fixed-to-floating interest rate swap. Here party A makes periodic interest payments to party B based on a variable interest rate of LIBOR +50 basis points.

Party B in turn makes periodic interest payments based on a fixed rate of 3%. 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.

Swaps are over-the-counter (OTC) derivatives. This means that they are negotiated outside exchanges. They cannot be bought and sold like securities or futures contracts, but are all unique. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC Derivatives market. At the end of 2004, this was USD 248.288 trillion (that is, USD 248,288 billion, or six times World GDP). The majority of this (USD 147.4 trillion) were interest rate swaps. These split by currency as:

	Notional outstanding in USD trillion
Currency	End 2000	End 2001	End 2002	End 2003	End 2004
Euro	16.6	20.9	31.5	44.7	59.3
US dollar	13.0	18.9	23.7	33.4	44.8
Japanese yen	11.1	10.1	12.8	17.4	21.5
Pound sterling	4.0	5.0	6.2	7.9	11.6
Swiss franc	1.1	1.2	1.5	2.0	2.7
Total	48.8	58.9	79.2	111.2	147.4

Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1]

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 set by the British Bankers Association, an independent trade body.

[edit] Interest Rate Swap

Main article: interest rate swap

Interest Rate swaps are the most common type of swap, also known as a 'plain vanilla' swap. They typically exchange fixed rate payments against floating rate payments. The principals are not exchanged, and are known as the notional principal. Exceptions exist, such as floating-to-floating swaps (known as basis swaps).

[edit] Total return swap

Main article: total return swap

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.

Total return swap (also known as total rate of return swap, or TRORS) is a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness of the reference asset, especially where the payments are based on the same notional amount. The reference asset may be any asset, index, or basket of assets.

The TRORS, then, allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (which does retain that asset on its balance sheet) to buy protection against a potential decline in its value.

The essential difference between a TRORS and a credit default swap is that the latter provides protection not against loss in asset value but against specific credit events. In a sense, a TRORS isn’t a credit derivative at all, in the sense that a CDS is. A TRORS is funding-cost arbitrage.

[edit] Equity Swap

Main article: 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.

[edit] Valuation

The value of a swap is the net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future cash flows is equal to zero.

For example, consider a plain vanilla fixed-to-floating 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

See: Rational pricing; Arbitrage