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What is Swap? Research Team | Posted On Tuesday, May 05,2009, 07:45 PM

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What is Swap?




What is a Swap?

In general Swap means the exchange of one asset or liability for a comparable asset or liability for the purpose of lengthening or shortening maturities or raising or lowering coupon rates to maximize revenue or minimize financing costs. This may entail selling one securities issue and buying another in foreign currency; it may entail buying a currency on the spot market and simultaneously selling it forward. Swaps also may involve exchanging income flows; for example, exchanging the fixed rate coupon stream of a bond for a variable rate payment stream or vice versa  while not swapping the principal component of the bond. Swaps are generally traded over-the-counter.

In finance a swap is a derivative in which two counterparties consent to exchange one stream of cash flow against another stream. These streams are called the legs of the swap. The cash flows are planned over a notional principal amount which is usually not exchanged among counterparties. As a result, swaps can be used to create unfunded exposures to an underlying asset since counterparties can earn the profit or loss from actions 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 wonder on changes in the expected direction of underlying prices.

Swap structure

A swap is an agreement among two parties to exchange future cash flows according to a prearranged formula. They can be regarded as portfolios of forward contracts. The streams of cash flows are called legs of the swap. Generally at the time when the agreement is initiated at least one of these series of cash flows is strong-minded by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price. Most swaps are traded over-the-counter (OTC), tailor-made for the counterparties.

Types of Swaps

  • Total swap
  • equity swap
  • Currency Swaps
  • Credit Swaps
  • Commodity swaps
  • Interest rate swaps

Total swap

A total return swap is a swap in which party A pays the sum return of an asset and party B makes periodic interest payments. The sum return is the capital gain or loss plus any interest or dividend payments. Note that if the sum return is negative, then party A receives this amount from party B. The parties have experience 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.

Equity Swap

An equity swap is a particular type of total return swap where the underlying asset is a stock a basket of stocks, or a stock index. Compared to really owning the stock in this case you do not have to pay something up front, but you do not have any voting or other rights that stock holders do have.

Currency swap

A currency swap or cross currency swap is a foreign exchange agreement among two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in an additional currency. Currency swaps are motivated by comparative advantage.

Credit swaps

A credit swap is a credit derivative agreement between two counterparties. The buyer makes periodic payments to the seller and in return receives a payoff if a fundamental financial instrument defaults.

Commodity swaps

A swap where exchanged cash flows are dependent on the price of an underlying commodity. This is frequently used to hedge against the price of a commodity.

Interest rate swaps

An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to run their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.

The most accepted interest rate swaps are fixed-for-floating swaps under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan. Among these the most common use a 3-month or 6-month Libor rate (or Euribor, if the currency is the Euro) as their floating rate. These are called vanilla interest rate swaps. There is also a liquid market for floating-floating interest rate swaps w hat are known as basis swaps.

To keep things simple and minimize settlement risk, concurrent cash flows are netted. In a typical arrangement both loans have an initial payment (loan) of principal but those net to 0. Mutually loans have a final return of the same principal but those also net to 0. Also, the periodic interest payments are normally scheduled to occur on concurrent dates so they too can be netted. The principal amount is called the notional amount of the swap.

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