A swap is a derivative contract between two parties to exchange pre-determined cash flows over a period of time.
Let’s understand this technical definition, in a simple manner.
In childhood, many of us had an obsession with a cartoon called Pokémon. There was also a card game based on the cartoon where each card was a different Pokémon. One who had the most exclusive cards were considered the coolest kid in the school.
Now, to climb the ladder of ‘coolness’, we traded one card for others. Sometimes, even multiple cards for the one shiny card. This is the basic concept of a swap.
A derivative contract derives its value from the underlying asset. The derivative contract in the above story is being more ‘cool’ and the underlying asset is the exclusivity of the Pokémon card. The two parties being the kids and the cash flows are the bragging rights among the friends.
In the world of finance, the exchange is a bit more complex. The parties to the swap are generally companies and financial organizations. The financial institutions that create a swap agreement are called ‘market makers’ while the institutions that facilitate the transactions by matching the counterparty are called ‘swap banks’.
A swap is not traded on a stock exchange rather it is traded over-the-counter (OTC) which means they are executed outside the trade market without the supervision and control of the exchange regulator.
The cash flow element of both parties is called ‘leg’ The cash flow could be fixed or variable in nature.
Therefore, there are two legs in a swap contract, one or both of which could be variable in nature but, both cannot be fixed.
The parties decide to take up swaps for two main reasons, i.e.
i. Commercial needs: When the nature of the business of the company leads it to have a certain exposure to risk which the company wishes to hedge by using swaps.
ii. Comparative advantage: When a firm has an advantage in borrowing in a certain market but it is not desirous for the company to have such financing, it can acquire its desired kind financing by entering into a swap.
Types of swaps:
i. Interest Rate Swaps: Parties agree to exchange one stream of interest in the future period against another based on the notional principal amount. Example: Fixed interest loan exchanged for a floating interest.
ii. Currency Swaps: These are the same as interest rate swaps with the only difference being, the legs of the swaps are represented in different currencies. These are entered to hedge against foreign exchange risk.
iii. Commodity Swaps: These swaps allow to exchange of cash flow based on the price of the underlying asset. As mentioned earlier, one leg is fixed while the other is variable.
Plain vanilla (simplest form of swap) interest rate swaps and currency swaps are the two most common types of swaps used in the market.
Some interesting facts about swaps:
i. The first interest rate swap occurred between IBM and the World Bank in 1981.
ii. Credit Default Swaps (CDS) provided the buyer with insurance against the default of the mortgages of houses. This meant the buyer has to pay the seller a premium for such insurance and on default of mortgages, the seller has to provide the buyer with the face value of the defaulted asset. These swaps became particularly notorious in the Global Financial Crisis of 2008.
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