What is a Swap?
A swap is a derivative contract between two parties that involves the exchange of pre-agreed cash flows of two financial instruments. The cash flows are usually determined using the notional principal amount (a predetermined nominal value). Each stream of the cash flows is called “leg.”
Introduced in the late 1980s, swaps are a relatively new type of derivatives. Even though relatively new, their simplicity coupled with their extensive applications, makes them one of the most frequently traded financial contracts in the world.
Corporate finance professionals may use swap contracts to hedge risk and minimize the uncertainty of certain operations. For example, sometimes projects can be exposed to exchange rate risk and the Company’s CFO may use a Currency swap contract as a hedging instrument.
Unlike futures and options, swaps are not traded on exchanges but are traded over-the-counter. In addition, counterparties in swaps are usually companies and financial organizations and not individuals, because there is always a high risk of counterparty default in swap contracts.
Some financial institutions usually participate as the market makers of swap markets. The institutions, which are also known as swap banks, facilitate the swap transactions by matching counterparties.
Types of Swaps
Modern financial markets employ a wide selection of swaps suitable for different purposes. The most popular types include:
#1 Interest rate swap
Counterparties agree to exchange one stream of future interest payments for another based on a predetermined notional principal amount. Generally, the interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.
#2 Currency swap
Counterparties exchange the principal amount and interest payments denominated in different currencies. Currency swaps are often used to hedge a position against currency exchange rates fluctuations.
#3 Commodity swap
It is designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed fixed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.
#4 Credit default swap
It provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case of the asset default, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps are notorious due to their impact on the 2008 Global Financial Crisis.
Applications of Swaps
Nowadays, swaps are an essential part of modern finance. They can be used in the following ways:
#1 Risks hedging
One of the primary functions of swaps is the hedging of risks. Interest rate swaps can hedge against interest rate fluctuations, currency swaps are used to hedge against currency exchange rates fluctuations, and commodity swaps are utilized to lock in the most suitable spot prices of a commodity.
#2 Access to new markets
Companies can use swaps as a tool for accessing previously unavailable markets. For example, a US company can opt to enter into a currency swap with a British company to access the more attractive dollar-to-pound exchange rate, because the UK-based firm can borrow domestically at a lower rate.
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