Swap (finance)
In finance, a swap is a derivative contract between two counterparties to exchange, for a certain time, financial instruments, unconventional cashflows, or payments. Most swaps involve the exchange of interest rate cash flows, based on a notional principal amount.
Unlike future, forward or option contracts, swaps do not usually involve the exchange of the principal during or at the end of the contract. In general, one cash flow, or leg, of the swap is generally fixed, while the other is floating and determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price.
Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps. They are often used to hedge certain risks, such as interest rate risk, or to speculate on the expected direction of underlying prices.
History
Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world; the total amount of interest rate and currency swaps outstanding was more than $348 trillion in 2010, according to Bank for International Settlements.Most swaps are traded over-the-counter and are drafted specifically for the counterparties. The United States's Dodd-Frank Act in 2010, however, established a multilateral platform for swap quoting, the swaps execution facility, mandating that swaps be reported to and cleared through exchanges or clearing houses. This subsequently led to the formation of swap data repositories, a central facility for swap data reporting and recordkeeping. Data vendors, such as Bloomberg, and large exchanges, such as the Chicago Mercantile Exchange, were among the first to register as SDRs. Other exchanges followed, such as the IntercontinentalExchange and Frankfurt-based Eurex AG.
According to the 2018 SEF Market Share Statistics, Bloomberg dominates the credit rate swap market with 80% share; TP dominates the FX dealer to dealer market ; Reuters dominates the FX dealer to client market ; Tradeweb is strongest in the vanilla interest rate swap market ; TP is the biggest platform in the basis swap market ; BGC dominates both the swaption and XCS markets; Tradition is the biggest platform for caps and floors.
Size of market
While the market for currency swaps developed first, the interest rate swap market has surpassed it, measured by notional principal, "a reference amount of principal for determining interest payments."The Bank for International Settlements publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. 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 majority of this was due to interest rate swaps. These split by currency as:
Major Swap Participant
A Major Swap Participant is a generic term to describe a financial institution that facilitates swaps between counterparties. It maintains a substantial position in swaps for any of the major swap categories. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. A swap bank serves as either a swap broker or swap dealer. As a broker, the swap bank matches counterparties but does not assume any risk of the swap. The swap broker receives a commission for this service. Today, most swap banks serve as dealers or market makers. As a market maker, a swap bank is willing to accept either side of a currency swap, and then later on-sell it, or match it with a counterparty. In this capacity, the swap bank assumes a position in the swap and therefore assumes some risks. 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.Swap market efficiency
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. Firms using currency swaps have statistically higher levels of long-term foreign-denominated debt than firms that use no currency derivatives. Conversely, the primary users of currency swaps are non-financial, global firms with long-term foreign-currency financing needs. From a foreign investor's perspective, valuation of foreign-currency debt would exclude the exposure effect that a domestic investor would see for such debt. Financing foreign-currency debt using domestic currency and a currency swap is therefore superior to financing directly with foreign-currency debt.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. Empirical evidence suggests that the spread between AAA-rated commercial paper and A-rated commercial is slightly less than the spread between AAA-rated five-year obligation and an A-rated obligation of the same tenor. These findings suggest that firms with lower credit ratings are more likely to pay fixed in swaps, and fixed-rate payers would use more short-term debt and have shorter debt maturity than floating-rate payers. In particular, the A-rated firm would borrow using commercial paper at a spread over the AAA rate and enter into a fixed-for-floating swap as payer.
Types of swaps
The generic types of swaps, in order of their quantitative importance, are: interest rate swaps, basis swaps, currency swaps, inflation swaps, credit default swaps, commodity swaps and equity swaps. There are also many other types of swaps.Interest rate swaps
The most common type of swap is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.
Basis swaps
A basis swap involves exchanging floating interest rates based on different money markets. The principal is not exchanged. The swap effectively limits the interest-rate risk as a result of having differing lending and borrowing rates.Currency swaps
A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.Just like interest rate swaps, the currency swaps are also motivated by comparative advantage.
Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction
being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.