Swaps – Definition & Types

2024-09-23Last Updated: 2024-09-23

A financial swap is a contract between two counterparties to exchange, or swap, a series of well-defined future cash flows.

Swaps are mainly used by institutional investors to manage risks, speculate or achieve other financial goals. For a swap contract to exist, there seem to be two requirements:

A net advantage to both counterparties
An intermediary to arrange the deal

This article will define what are swaps and we will go through the different types of swaps available in the market.

What are Swaps?

A swap is a derivative contract where two parties exchange financial instruments, usually cash flows or liabilities. The most common types of swaps are interest rate, currency or commodity. These are private and customizable, so they are very useful for hedging and risk management.

Swaps are traded over-the-counter (OTC), meaning they are negotiated between two parties rather than on an exchange. This gives you the flexibility to customize the terms to your needs but also introduces counterparty risk, as the deal is dependent on the other party to perform.

The most popular types include:

Interest Rate Swaps
Currency Swaps
Equity Swaps
Commodity Swaps
Credit Default Swaps (CDS)

1. Interest Rate Swaps

Interest rate swaps are the most common type of swap. They involve the exchange of interest rate cash flows between two parties, swapping fixed for floating or floating for fixed.

The two parties exchange the interest payments on a notional principal. Typically, one side pays a fixed interest rate and the other party pays a floating interest rate (usually, the 6-month LIBOR).

Fixed for Floating

In a fixed for floating interest rate swap one party pays a fixed rate and receives a floating rate based on a reference rate. This type of swap is used to manage interest rate risk, to convert variable rate debt to fixed rate or vice versa.

Basis

Basis swaps involve the exchange of two floating rates based on different reference rates. For example a swap might exchange LIBOR for federal funds rate. These swaps are used to manage basis risk, the difference between two rates.

There are several versions of interest rate swaps, some of which are:

Amortizing / accreting swap: notional principal is reduced / increased over
the life of the swap
Constant yield swaps: both sides are floating
Rate-capped swaps: the floating rate is capped
Puttable and callable swaps: parties have the option to cancel the swap at
certain times
Forward (or, deferred) swaps: regular swap to be initiated at a future date
Extendible swaps: the maturity may be extended by the holder at the
original swap rate

2. Currency Swaps

A currency swap is a contract to swap a series of cash flows in one currency with a series of cash flows in another currency. Typically, it involves the exchange of both interest payments and also principal.

Currency swaps involve exchanging principal and interest payments in different currencies. They are used to hedge foreign exchange risk or get cheaper financing in a foreign currency.

Fixed-Fixed Currency Swaps

In a fixed-fixed currency swap, both parties exchange fixed interest payments in different currencies. For example a US company might exchange fixed rate dollar payments for fixed rate euro payments with a European company.

Fixed-Floating Currency Swaps

In a fixed-floating currency swap, one party pays a fixed rate in one currency and the other party pays a floating rate in another currency. This type of swap can be used to manage interest rate risk and currency risk.

3. Equity Swaps

Equity swaps may be used to change the risk exposure of a fund, which is closely correlated with the reference index. One pays a fixed or floating rate and receives returns based on an equity index like the S&P 500.

Equity swaps are used for hedging, market access or synthetic exposure to equities without owning the underlying.

There are several variants of equity swaps:

Instead of a fixed rate, a floating rate based on the LIBOR may be used.
A variable notional principal may be used.
A cap and/or a floor may be placed on the index return.
The return on a single stock may be swapped with the return on another stock.

4. Commodity Swaps

A commodity swap is a contract where a variable price based on a notional quantity of an underlying commodity is swapped for a fixed price on the same commodity over a specified time period. There is no physical delivery at expiry.

The variable price is typically an average spot price over a predefined period. The most popular commodity swaps are on gas, oil and electricity. Producers and consumers of commodities use these to hedge against price moves.

Fixed for Floating Commodity Swaps

In a fixed for floating commodity swap one party pays a fixed price for a commodity and the other party pays a floating price based on the market. For example an airline might enter into a swap to lock in a fixed price for jet fuel and hedge against price increases.

5. Credit Default Swaps (CDS)

Credit default swaps are a type of credit derivative where one party can transfer the credit risk of a reference entity to another party. In a CDS the buyer pays premiums to the seller and in return the seller pays compensation if the reference entity defaults or experiences a credit event.

CDS are used to hedge credit risk or to speculate on the creditworthiness of a company or country. They were a major part of the 2008 financial crisis and showed both their use and risks.

In Conclusion

Swaps are powerful financial tools that are at the heart of modern finance. They help you manage different types of risk; interest rate risk, currency risk, equity risk, commodity price risk and credit risk. By knowing the different types of swaps and how they are used, you can navigate the financial markets better and implement risk management.