Definition of Swap in Finance
A swap in finance is an arrangement combined with a derivative contract between two parties, which results in an exchange of a stream of cash flows taking a notional principal amount as a base. Such instruments may be looked upon as a portfolio of forwarding contracts contract designed for multiple times betting.
- “Swap” means to exchange. A swap in finance means an exchange instrument used to exchange the cashflows between the parties.
- Consider you require funds with an interest rate that mimics the changes in the market interest rate, but the lender provides you with discounted fixed interest rate. In this case, the floating interest rate is costlier than the fixed interest rate. So, you search for another person in the market who needs a fixed interest rate & has been offered a floating interest rate by his lender.
- You can then agree upon with that other person wherein he will pay you a fixed interest rate, and you will pay him the floating interest. This way, your effective cost is what you want to pay, i.e. “floating interest rate”.
- Other than the finance market, swaps can be widely used commodities market, currency market, deb-equity, etc., and there is no outer boundary.
- Swaps are famous in today’s finance regime due to their quickness in application and easiness in their operations.
Features of Swap in Finance
- Basically, a swap has to be entered between at least two parties. It means more than two parties are possible when a third person is involved as an intermediary.
- Both the parties will have similar exposure in the market.
- One of the parties has an absolute advantage in one market, which the other party does not have.
- In case of unequal exposures, the banks charge nominal fees to make the exposure equal.
- The end result of the swap will be financial savings as compared to normal operations for both the entities. This happens in most cases.
- Each party needs to manage their debt issues and are exposed to funding cost. Each party wants to reduce their funding cost.
How Does It Work?
- Swaps entered in the financial world are generic or plain vanilla swaps, in most cases. Here, there are two legs in the swap. One is floating, and the other is fixed. The principal amount would be notional, i.e. no exchange of actual principal amount between two parties.
- We will study the different types of swaps in the later part of this topic. But basically, every swap starts with one party who wants a specific type of exposure which the lender cannot provide.
- Taking the base of interest rate swap, one party applies for a business loan with a fixed rate of interest. However, the lender offers only the floating rate of interest, which is trading at a discount. Party one will accept the floating rate of interest, but it needs to keep its exposure fixed.
- Say another party (i.e. party two) has taken a loan with a fixed rate of interest, but it has speculation that the interest rates in future will reduce drastically, and thus it wants a floating interest rate.
- A banker identifies such demand and supply components, and an arrangement is made between the three parties to regulate the swap.
- Under this agreement, party one will pay a floating interest rate to its lender and a fixed interest rate to the banker, which the banker will pass on to the party two. Further, party two will pay a fixed interest rate to its lender and a floating interest rate to the banker, which the banker will pass on to the party one.
- Each party pays something and receives something in return so that the net cost is something that each party desired. A banker will charge a fixed commission to both the parties.
- This way, a swap is arranged between two unknown parties.
Example of Swap in Finance
Say, Firm A & B wish to borrow 5 years funds from the market:
|Fixed Market||Floating Market||
|A||8%||L + 2%||Floating|
|B||10%||L + 1%||Fixed|
Show how a swap can be arranged to reduce the preferred cost of funding for each firm.
Step 1: Data
|Fixed Market||Floating Market||
|A||8%||L + 2%||Floating|
|B||10%||L + 1%||Fixed|
A enjoys an absolute advantage in a fixed market, while B enjoys an absolute advantage in a floating market. So, A should borrow fixed @ 8%, and B should borrow floating @ L+1%. They should then enter into a swap.
Green highlighted the desired funding requirement.
For Firm A,
It will pay 8% to the lender outside and recover 8 from Firm B. Thus, its effective cost is restricted to what it has paid to Firm B, i.e. L + 1% as agreed.
For Firm B,
It will pay L + 1% to the lender outside and recover the same from Firm A. Thus, its effective cost is restricted to what it has paid to Firm A, i.e. 8% as agreed.
Step 2: Presentation
|A||L + 2%||L + 1%||1%|
Types of Swap in Finance
Once you understand the basic methodology of swaps, you can easily guess the working methodology of other swaps. Just focus on the legs in each swap.
- Interest rate swap: One leg is floating interest, while the other leg is fixed interest rate.
- Currency Swap: Both legs of the swap are in different currencies. It helps to hedge the position against currency fluctuations.
- Equity swap: Here, atleast one of the legs is a return from an equity instrument. It may be exchanged with return from bonds or portfolio, etc.
- Commodity swap: Here, atleast one leg is based on commodity price, which can be exchanged with fixed or floating cash flows from another commodity.
- Credit Default Swap: It is famously called CDS, wherein the seller of swap will reimburse the buyer with the face of the asset, which is defaulted along with transfer of asset.
- Total Return Swap: Here, one leg is a total return from an asset, and the other leg is a fixed return from an index.
Valuation of Swap in Finance
- Swap is nothing but exchange of a stream of cash flows, and thus its valuation is quite easy and sensible.
- One party in the swap wants to pay fixed, and the other party wants to pay to float. Thus, the value of a swap for a fixed-payer is the difference between the present value of balance payments in a floating interest paying instrument and the present value of balance payments in a fixed interest paying instrument.
- The value of swap for a floating-payer is the difference between the present value of balance payments in a fixed interest paying instrument and the present value of balance payments in a floating interest paying instrument.
- However, the pricing of the swap generally referred to as the “fixed rate of the swap”, and it is decided today such that the value of the swap is zero, i.e. the value of fixed instrument equals the value of the floating instrument.
- One should note that the value of a floating coupon bond will be equal to the notional principal as on the date of settlement will always be equal to the par value of the bond.
Uses of Swap in Finance
- Mainly, it is entered for interest rate swaps to reduce the cost of funding and obtain the desired funding method.
- It is used to exploit the comparative advantage in one market.
- It may be used in trading in various financial instruments.
- It provides a sufficient hedge against unfavourable movements.
- Many broker houses and bankers use swaps as a tool to manage the assets and liabilities.
Application of Swap in Finance
- Swaps have a wide range of applications, as explained in the various types of swaps. The outbound for the application of swaps is unlimited.
- It is mainly used in hedging against some risk. Risk can be envisaged in currency rate fluctuations or interest rate fluctuations.
- It provides easy access to different segments of different markets. Some of the markets in the financial world are not directly accessible to everyone.
- Swaps can also be used in trading the Overnight Index Swaps (OLS), where floating rate, i.e. MIBOR, is subject to daily compounding.
- Double swaps may be entered to reduce the effective cost of funding. Here, a firm issues a hybrid instrument, i.e. an instrument which pay a fixed rate for certain years and a floating rate for another certain year. The objective of the firm is a fixed rate of funding throughout the tenure.
- Two-party swaps are also arranged to exploit the comparative advantage avoiding the banker as an intermediary.
Swaps are extensively used in financial markets. It basically provides a hedge against a defined set of exposures. The parties in the swap get the desired type of funding costs, and it also saves on the desired funding cost. In rare circumstances, the swap results in a loss for both the parties.
This is a guide to Swap in Finance. Here we also discuss the definition and how does it work? Along with types and example. You may also have a look at the following articles to learn more –