Financial derivative types: Swaps

Swap is yet another exciting trading instrument. Infact, it is a combination of forwards by two counterparties. It is arranged to reap the benefits arising from the fluctuation in the market – either currency market or interest rate market or any other market for that matter.

Features of swap:

The following are the important features of swap:

  • Basically a forward: A swap is nothing but a combination of forwards. So, it has all the properties of a forward contract discussed above.
  • Double coincidence of wants: Swap requires that two parties with equal and opposite needs must come into contact with each other. As stated earlier, it is a combination of forwards by two counterparties with opposite but matching needs. For instance, the rate of interest differs from market to market and within the market itself. It varies from borrowers to borrowers due to the relative credit worthiness of borrowers. Therefore, borrowers enjoying comparative credit advantage in floating rate debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying comparative advantage in fixed interest rate debt, like bonds. In a bond market, lending is done at a fixed rate for a long duration, and therefore, the lenders do not have the opportunity to adjust the interest rate according to the situation prevailing in the market. So, the lenders are very much concerned with the credit worthiness of borrowers and they expect a premium for the risk involved. This premium is rather high in the case of less credit worthy borrowers. On the other hand, in the short term market, the lenders have the flexibility to adjust the floating interest rate (short term rate) according to the conditions prevailing in the market as well as the current financial position of the borrower. Hence, the short term floating interest rate is cheaper to the borrower with low credit rating when compared with the fixed rate of interest. But, for borrowers with high credit rating, both these rates are cheaper. But, their advantage is comparatively higher in the case of fixed rate debt instruments. Naturally, a borrower with high credit rating will go for long term funds while a borrower with low credit rating will opt for short term funds at floating rates. In such a situation, if the borrower with low credit rating wants long term funds at fixed rates, he has to swap the floating rate of interest with fixed rate interest with counterparty (borrower with high credit rating). Thus, two borrowers must have opposite and matching needs.
  • Necessity of an intermediary: Swap requires the existence of two counterparties with opposite but matching needs. This has created a necessity for an intermediary to connect both the parties. By arranging swaps, these intermediaries can earn income also. Financial companies, particularly banks can play a key role in this innovative field by virtue of their special position in the financial market and their knowledge of the diverse needs of the customers.
  • Settlement: Though a specified principal amount is mentioned in the swap agreement, there is no exchange of principal. On the other hand, a stream of fixed rate interest is exchanged for a floating rate of interest, and thus, there are streams of cash flows rather than single payment. For instance, one party agrees to pay a fixed rate interest to another party, and at the same time, he agrees to receive a floating rate interest from the same party. Both these rates are calculated on a notional principal and there is a continuous exchange of interest rates during the currency of the agreement. There is no such thing as single payment on the due date.
  • Long term agreement: Generally, forwards are arranged for short period only. Long dated forward rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate fluctuations etc. But, swaps are in the nature of long term agreement and they are like long dated forward rate contracts. The exchange of a fixed rate for a floating rate requires a comparatively longer period.

Types of swap:

A swap can be arranged for the exchange of currencies, interest rates etc. A swap in which two currencies are exchanged is called cross-currency swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called interest rate swap. This interest rate swap can also be arranged in multi-currencies. A swap in which one stream of floating interest rate is exchanged for another stream of floating interest rate is called ‘Basis swap’. Thus, swap can be arranged according to the requirements of the parties concerned and many innovative swap instruments can be evolved like this.

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