Swap (finance)
In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time.
This principal usually does not change hands during or at the end of the swap; this is contrary to a future, a forward or an option.
In the end there are two streams of cash flows, one from the party who is always paying a fixed interest on the notional amount, the fixed leg of the swap, the other from the party who agreed to pay the floating rate, the floating leg.
"[15] The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market.
However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product—which is also a cash-flow measure.
The dealer capacity is obviously more risky, and the swap bank would receive a portion of the cash flows passed through it to compensate it for bearing this risk.
[1][16] The two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and/or the benefit of hedging long-run exchange rate exposure.
These reasons seem straightforward and difficult to argue with, especially to the extent that name recognition is truly important in raising funds in the international bond market.
[17] Conversely, the primary users of currency swaps are non-financial, global firms with long-term foreign-currency financing needs.
[18] The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a cost savings via the quality spread differential (QSD).
In particular, the A-rated firm would borrow using commercial paper at a spread over the AAA rate and enter into a (short-term) fixed-for-floating swap as payer.
Party A in return makes periodic interest payments based on a fixed rate of 8.65%.
In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.
A basis swap involves exchanging floating interest rates based on different money markets.
The swap effectively limits the interest-rate risk as a result of having differing lending and borrowing rates.
An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms.
In the event of default, the payer receives compensation, for example the principal, possibly plus all fixed rate payments until the end of the swap agreement, or any other way that suits the protection buyer or both counterparties.
A swap is thus "worth zero" when it is first initiated, otherwise one party would be at an advantage, and arbitrage would be possible; however after this time its value may become positive or negative.
For interest rate swaps, there are in fact two methods, which will (must) return the same value: in terms of bond prices, or as a portfolio of forward contracts.
As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero.
