Swap Derivatives and Types – An Overview
Swaps and Swap Trading
A derivatives contract is one of the best expansion and trading documents for investors and traders.
A swap derivative is a contract between parties that exchanges cash flows for a set period of time from different financial instruments. The basis for most of the swaps involves notional principal amounts like bonds or loans.
The instrument in a swap can be anything legal that has financial value.
Generally, the principal amount stays with the real owner and does not change hands in the swap contract.
Though one of the cash flows might remain unchanged, the other one keeps changing and is based on a benchmark interest rate, a floating currency exchange rate, or an index rate.
At the beginning of the contract, one of the series of cash flows is determined by an inconsistent variable, like an interest rate, foreign exchange rate, commodity price, or equity price.
Working of Swap Trading
Swap trading operates when two parties agree to swap their cash flows or liabilities on two separate financial instruments. The most common of these swaps are interest rate swaps. A swap is not uniform, it doesn’t trade on a stock exchange, and it is uncommon for retail investors to get involved in a swap.
The contracts of swaps are dealt over the counter between businesses and financial institutions. The terms and conditions are negotiable and can be customised as per the needs of both parties. There is risk involved in swap contracts, as they occur on a counter market, and one party can default on the payment.
Types of Swaps
There are uncountable variations in swap agreements. Out of those, some of the most common ones are shared below:
Interest Rate Swaps: Interest Rate Swaps are meant to change the fixed interest rate to a floating interest rate for cashflows. In such swaps, one party, X, gives consent to pay a fixed amount to party Y on a notional basis for a predetermined period at fixed intervals.
To balance its foreign reserves, China used this swap with Argentina. In addition, the Federal Reserve of the United States used this currency swap to enter into currency swap agreements with European central banks. This currency swap was used by them in the 2010 financial crisis in Europe to balance the euros that had been deteriorating due to the Greek debt crisis.
Currency Swaps: Currency swaps refer to those swaps where the two parties interchange principal and interest payments on debt that is denominated in separate currencies agreed upon by both parties. The principle is notional in interest rate swaps, but this is not the case with currency swaps. The principle is not theoretical and is changed along with interest obligations in currency swaps.
Currency swaps can also occur between two countries.
Here, Party Y gives consent to pay Party X on a floating interest rate with the unchanged notional principle, the same amount of time, and the same intervals. The currency used to pay the cash flows in an interest swap is the same and is also known as a “plain vanilla interest swap.”
The agreed payment dates are called settlement dates, and the time in between them is known as the settlement period. Swaps are negotiable and customised contracts, so the payments can be done monthly, quarterly, annually, or as decided by both parties.
Total Returns Swap: In these swaps, the complete return from a particular asset is exchanged for a fixed interest rate. Also, the party paying the fixed rate takes on the discovery of the primary asset, whether a stock or an index.
For example, considering capital appreciation and earning dividend payments, an investor can pay a predetermined price to a party in return for stocks.
Commodity Swaps: These kinds of swaps are used to swap cash flows that are based on a commodity price. With the floating price of commodities, any one party can swap the floating rate for a fixed rate. For instance, the spot price of Brent Crude Oil can be exchanged for a price that is set over a predetermined period by producers. As a result of this, producers can lock in a set price and alleviate losses based on future price fluctuations.
Debt-Equity Swaps: In this sort of swap, the equity is exchanged for debt and vice versa. It is a process for financial reorganisation in which one party swaps or alleviates the debts of another party in return for an equity position. For a public trading company, this is swapping bonds for stocks. Debt-equity swaps are a way for a firm to recapitalize its debt and change its capital structure.
Credit Default Swap: Credit Default Swaps, or CDS, refer to those swaps involving an agreement by one party that provides insurance to another party if a third party cannot pay on a loan provided by the second party. In this kind of swap, the first party recommends paying the principal amount that is gone and the interest on a loan to the credit default swap buyer, considering that the borrower is unable to pay on their loan.
Conclusion
A swap is a derivative contract between two parties. In this contract, one party will swap the value of cash or an asset with the other. For instance, consider that X company, which is paying variable interest, can exchange its interest payments with Y company. The company Y will then pay a fixed rate to the X company.
Other than this, swaps can be used to swap other types of values or risks, such as the potential for a credit default in a bond.
From this brief information about swaps, swap derivatives, the workings of swaps, and types of swaps, you must be clear about the topic in detail. If you need more relevant information about swap derivatives or other financial investments, head on over to Piramal Finance.
Happy investing!