What is a Swap?
A swap in finance is a contract in which two parties agree to exchange the cash flows of one financial instrument for another.
🤔 Understanding swaps
A swap is a contract used by investors to exchange the cash flows of one financial instrument for the cash flows of another, for a period of time. Swaps are based on cash flows from underlying assets the parties own, such as interest-bearing debts, commodities prices, or currency. Interest-rate swaps are the most common and usually involve exchanging a fixed-rate instrument (one that pays a set amount) for one with a floating rate (which varies over time). Parties typically enter into swaps when they want to reduce risk, manage borrowing costs or cash flow, or profit from predictions about how markets will move in the future. Both parties are hoping that the deal will work to their advantage.
Suppose an investment bank called Ivory has taken out a variable rate loan. Ivory isn’t sure which way interest rates will go, but isn’t comfortable with the risk that they’ll rise in the near future. Ivory enters into an interest rate swap for two years with a company called Violet. Violet believes that interest rates are about to drop, so it agrees to pay Ivory’s variable rate, while Ivory agrees to pay Violet’s fixed rate of 4.5%.
If the variable interest rate, which is based on market interest rates, drops below 4.5%, Violet will make money. Even though Ivory could end up paying more than it would otherwise, it can still benefit by eliminating uncertainty. Each company sees the deal as beneficial.
A swap is like trading baseball cards with a friend…
Many people collect baseball cards in hopes that they’ll be worth something in the future. When collectors trade cards with fellow enthusiasts, they’re betting that the cards they get will become more valuable than the ones they give away. Swap contracts in finance work similarly, except participants are making guesses about the performance of a financial instrument instead of a baseball card.
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What is a swap?
A swap is a contractual agreement in which two parties agree to exchange (or swap) cash flows. The cash flows in a swap are based on an underlying financial instrument, such as an interest-bearing debt or a currency. The most common type of swap is an interest-rate swap. Risk management is often the primary purpose of entering into a swap — for example, trading the uncertainty of a variable rate for the stability of a fixed rate. Some entities go into swaps to manage cash flow or borrowing costs. Others take part in swaps as a form of speculation — They anticipate a change in the market and want to profit from it.
What are the types of swaps?
Swaps vary based on the underlying financial asset cash flows come from. Common types include:
- Interest-rate swap: The most common type of swap, interest rate swaps take place when two parties exchange interest payments for a period of time. Often these swaps involve trading the cash flows of an asset paying a fixed interest rate for one paying a variable rate. Some parties enter into interest rate swaps when they’ve taken on debt with a variable rate but want the security of a fixed rate. Others may enter into a swap to make a profit if they think interest rates are going to increase or decrease. The party paying the fixed rate hopes that it will be lower than the variable rate, or just prefers to have more certainty. The other party hopes that the variable rate will fall below the fixed rate. The variable rate is often based on the London InterBank Offered Rate (LIBOR), which is the interest rate at which a number of international banks are currently lending each other money.
- Currency swap: A currency swap occurs when two parties exchange the interest rate payments and principal for debt obligations in one foreign currency for the same payments in another currency for a period of time. The two parties exchange principals at the beginning of the swap, and then trade interest rate payments. In the end, the parties switch the principal amounts back again. This helps the parties manage currency risk, or the potential for losses due to changing currency exchange rates.
- Equity swap: In an equity swap, one party exchanges the cash flows of a particular equity security, like stock, for a fixed-income cash flow. The fixed-income cash flow is generally based on a benchmark interest rate. Someone might enter into an equity swap to avoid paying fees for trading equities, to hedge against losses without giving up ownership rights, or to invest in securities that might otherwise be unavailable.
- Credit-default swap: In a credit default swap, one party pays another to assume the default risk of a particular debt. A lender may buy a credit default swap to protect itself from financial loss in case a borrower stops paying their debt. The seller, who owns the underlying asset, pays the buyer a regular fee. In exchange, the buyer agrees to pay the seller a certain amount if the borrower defaults.
- Commodity swap: This is when the parties exchange the cash flows of an underlying commodity, like oil, metals, or agricultural items. Commodity swaps are often used to protect against risk due to changes in the market price of the underlying product.
What is the difference between swaps and futures?
Swaps and futures are both agreements that involve making a prediction about what will happen in the future, but they’re not the same. While swaps are a contractual agreement to exchange the cash flows of a particular asset, a future is an agreement to buy or sell the asset itself. When two parties enter into a futures contract, they agree that one of them will sell an underlying security to the other at a set price on a particular date in the future. Futures contracts are traded on an exchange and settled daily (meaning the parties exchange payments) based on increases and decreases in the market.
As with a swap, parties entering into a futures contract are betting that what happens in the future will leave them with the better end of the deal.
For example, suppose you’re entering into a futures contract in which you agree to sell someone oil for a particular price on a particular date. You think the market price of oil is going to drop, so you’ll be able to get more money from the sale than you would selling it in the market at the time. The buyer is hoping that oil prices will go up, meaning they’ll get to buy the asset for less than the market price.
What is the difference between swaps and options?
When two parties enter into a swap, they agree to trade the cash flows of specific financial instruments. An option is a contractual agreement where two parties agree to exchange something, but these contracts work very differently.
First, options contracts involve trading actual securities, not just their cash flows. Another difference is that with an option, only one party has an obligation (i.e. the seller) whereas in a swap both parties have an obligation to exchange the cash flow.
An options contract gives one party the right to either buy or sell an underlying security at a certain price until a particular date in the future. The party who bought the option has the right, but not the obligation, to exercise the contract. The party who sold the option doesn’t have a choice — If the other party wants to exercise the contract, the seller is contractually obligated to go along with it.
There are two different types of options. A put option is one in which the buyer has the right to sell shares of a particular stock at the strike price (the price the two parties agreed on) on or before a particular date (the expiration date). A call option is where the buyer of the contract has the right to buy the underlying security from the other party at the strike price on or before the expiration date.
What is the difference between swaps and forwards?
Forward contracts are similar to futures contracts in that one party agrees to sell a particular asset to another for a set price on a specific date in the future. Unlike futures contracts, forwards are over-the-counter (OTC) contracts, meaning they are not bought and sold on an exchange. Instead, they are private deals, which allows them to be more customizable. Compared to futures, forwards more often result in assets actually being delivered on a specified date, rather than being settled in cash.
Swaps and forwards differ in a couple of ways. First, forward contracts involve the two parties agreeing to trade an asset, not just its cash flows (as is the case with swaps). Additionally, swaps are ongoing while forwards settle just once when the contract reaches maturity.
What is the difference between swaps and derivatives?
Swaps, futures, options, and forwards are all types of financial derivatives. A derivative is a contract whose value is based on the performance of an underlying asset. When two parties enter into a derivatives contract, they’re agreeing to make a particular type of trade. In the case of a swap, they’re trading the cash flows of a specific asset. In other cases, they might give someone the option to buy or sell a security in the future. Each party is hoping the market will move in his or her favor before the contract expires. Derivatives can be traded on an exchange, but most are private contracts between two parties.
What are the applications of swaps?
One reason that investors enter into swaps is to manage risk. Suppose a company borrowed money, and the only loan it could get had a variable interest rate. The company isn’t comfortable with the risk of the interest rate going up and would rather have the guarantee of a fixed interest rate. It enters a swap that switches its variable interest rate payment for another party’s fixed interest rate payment. Even if the variable interest rate ends up being lower than the fixed rate, at least the swap gives the company peace of mind that it won’t go up in the future.
The other primary use of swaps is for speculation, meaning entering into deals in hopes of making money. Consider the example of a company with a floating-rate loan that wants the security of a fixed-rate loan. That company’s motivation for entering into the swap is to manage its risk. But the other party might enter into the deal in the hopes that interest rates will drop and it’ll get to pay the lower interest rate. Parties might also use swaps to get into markets previously unavailable to them, such as currencies and commodities.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risks. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com/about/publications/character-risks.jsp.
The investment strategies discussed in this article are complex and for experienced traders only. The risk involved with these strategies includes not only risk to invested principal, but also losses in addition to the initial investment.
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