What are Swaps in Derivatives?
Swaps in derivatives is a contract or agreement between two parties where they can exchange liabilities or cash flows from two different financial instruments. Most swaps involve cash flows based on a notional principal amount on bonds or loans. However, the underlying instrument used in swaps can be any instrument with legal or financial value.
Usually, there is no transfer of the principal amount in a swap contract. Also, one cash flow remains fixed, and the other remains variable. The variable cash flow is based on the currency exchange rate, benchmark interest rate, or index rate. Furthermore, every exchange of cash flow is known as ‘leg’.
At the time of initiating the contract, at least one of the cash flows is determined through uncertain or random variables like the foreign exchange rate, equity price, interest rate or commodity price.
The most common type of swap in derivatives is the interest rate swap. Also, these are not traded on the stock exchange and are considered over-the-counter (OTC) contracts. Usually, financial institutions or businesses participate in swap transactions and can be customized based on the demand of both parties. Whereas, it is not prevalent among retail investors because it involves a high risk of counterparty default.
A swaps in derivative contract consists of the following –
- Start and end date of the swap
- Nominal amount
- Payment Frequency
- Margin or interest rate
- Reference index
How Do Swaps Work?
Every swap contract is unique and tailor-made. There is no standardized format. The parties enter into the contract based on the negotiations and conditions they agree upon. Also, this contract is based on the notional principal amount, and the cash flows earned are exchanged between the parties. The exchange of cash flows takes place during the specific time period as per the frequencies mentioned, i.e. between the start and end date of the contract.
No financial regulator oversees these contracts because they are traded over the counter. Thus, the chances of counterparty default increase, making them a risky instrument. Moreover, different swap contracts operate differently, and every type of swap has a specific purpose.
Usually, companies use swaps to hedge the risk in their businesses and reduce the uncertainty in operations. For instance, large companies finance their business by issuing bonds that pay interest to investors. However, if the company is uncomfortable with the interest payments, it would look for another company for a swap.
Suppose company A issues bonds with variable interest rate but is worried about the rising rates. In such a case, it will look for another firm that may agree to pay the bond interest for it.
If company B agrees to pay interest for company A, it may ask for a fixed rate interest payment on a set amount of money. If the interest rates rise, company A will benefit more because it pays less interest to company B. But if the interest rates fall, company B will benefit because it will receive more from company A.
Types of Swaps
The following are the most common types of swaps used in the Indian capital markets –
Interest Rate Swap
Interest rate swaps, also known as plain vanilla swap contracts, counterparties exchange cash flows to hedge the interest rate risk or speculate. Generally, these contracts involve the exchange of a fixed interest rate for a floating interest rate. The cash flows depend on the notional principal amount, which is agreed upon by both parties, and this amount is not exchanged initially.
For instance, party X pays party Y at a fixed interest rate for a specific period on specific dates. Following this, party Y agrees to pay party X on a floating interest rate with the same notional principal amount on the same dates. The currency used in both cash flows is the same, and both parties also preset the dates. These dates are called settlement dates. Furthermore, the payments are made monthly, quarterly or annually, depending on the time interval set by the counterparties.
Commodity swaps involve the exchange of cash flows that is dependent on the commodity price. This contract consists of two components, namely floating leg and fixed leg. The floating leg is linked to the market price of the underlying commodity like oil, fuel, precious metals, etc. The fixed leg is specified in the contract as per the commodity producer.
Generally, crude oil is the most common commodity swap and involves large institutions due to the nature and size of the contract. They use these swaps to hedge against the price change in the market of valuable commodities.
This swap involves the exchange of both interest and principal payments on debt denominated in different currencies. Also, it is not based on a notional principal amount but exchanged along with certain interest obligations. Moreover, these contracts take place between different countries.
For instance, the US Federal Reserve and European Central Banks engaged in an aggressive swap strategy to stabilize Euro, as its value was falling due to the Greek debt crisis.
The debt-equity swap deals with the exchange of debt and equity or vice-versa. This is a financial restructuring process where one party exchanges another party’s debt in exchange for an equity position. In other words, the debt holder gets an equity position to cancel the debt. There are some debt holders who have to agree to this contract due to bankruptcy, while others may have a choice to engage in these contracts where they can reap the benefits of favourable market conditions. Generally, publicly listed companies use this strategy to refinance their debt or relocate their capital structure.
For instance, the company offers attractive trade ratios like 1:2, where the bondholder receives stocks worth twice the value of the bonds, which makes the contract more enticing.
Total Return Swaps
The total return swaps involve the exchange of total returns from an asset from a fixed interest rate. This exposes the party to pay a fixed rate for the underlying asset, which is usually a stock, bond or index. Therefore, the second party reaps the benefits from this asset without actually owning it. The parties involved in this swap contract are called the total return payer and total return receiver.
For instance, an investor can pay a fixed rate to a party in return for exposure to stocks for capital appreciation and earning dividends.
Credit Default Swaps (CDS)
It is an agreement by a party that offers insurance to the second party if the third party defaults on the loan offered by the second party. The first party offers to pay the lost principal and interest amount of the loan to the CDS buyer in case the borrower defaults on the loan.
For instance, in the 2008 financial crisis, CDS was one of the significant contributing factors along with poor risk management and excessive leverage as investors were offsetting the credit risk with another investor. These contracts usually involved mortgage-backed securities, municipal bonds or corporate bonds.
Explore: Corporate Bonds
Benefits and Risks of Swaps Derivatives
The following are the benefits of swaps in derivatives –
- Hedging Risk: The primary benefit of swaps is hedging of risks. In other words, it can help a party to reduce the risk due to market fluctuations. For instance, interest rate swaps are used to hedge risk against interest rate fluctuations, while currency swaps are used to hedge against currency exchange rate fluctuations.
- Access to New Markets: These contracts allow investors or companies to venture into new markets that were previously unavailable. For instance, a US company can enter into a currency swap with a British company to access a more attractive dollar-to-pound exchange rate. This is because UK companies can domestically borrow at a lower rate.
The following are the major risks of swaps in derivatives –
- Interest Rate Risk: The interest movements do not necessarily match the expectations of these swap contracts. This makes them prone to the risk associated with interest rates. In other words, the receiver will profit only if the interest rate falls, while the payer will profit only if the interest rate increases.
- Credit Risk: Swaps are prone to the credit risk of the counterparty. This happens when the other party in the contract tends to default on the payments. However, this risk can be mitigated only to an extent.
Frequently Asked Questions
The interest rate swap contracts involve the parties exchanging the cashflows on a principal amount to hedge against the interest rate risk or speculation. Generally, these swaps involve the exchange of a fixed interest rate for a floating interest rate agreed upon by both parties.
A swap curve describes the relationship between the swap rates at different maturities. A swap curve is important while understanding the interest rate benchmark. Also, the swap curve and the sovereign yield curve are in a similar shape. And they can trade either higher or lower than the sovereign yield. The difference between the two is the swap spread.
The RBI’s Dollar-Rupee Swap Auction is a tool to manage the forex liquidity and stabilize the rupee value. The central bank announced a six-month swap period for this auction. As per the swap, RBI would give $2 billion (in exchange for the Indian rupee) to banks who wish to enter. This would infuse dollars into the market and improve liquidity. Also, banks with a significant outflow of dollars can replenish their reserves. However, this was a sell-buy swap deal. It means that simultaneously, the two parties entered into a contract where this transaction was reversed after six months. Here, the banks would sell the US dollars for INR to the RBI, who promised to buy it from them. Therefore, this move was able to normalize the effects of global turmoil and minimize the impact on Indian financial markets.