What are swaps?

A swap is a derivative contract in which two parties are agreed to exchange their cash flows from two different financial instruments for a defined period. In swap contracts, cash flows from one financial instrument are fixed and cash flow from other financial instruments is variable based on the interest rate, exchange rate, and commodity price. Swap contracts are transacted in an over-the-counter system. Swap contracts are utilized to hedge risk and mitigate loss.

Types of swaps

Different types of swaps are utilized for different purposes. These are:

Interest rate swaps

Interest rate swaps are financial derivatives that involve the transfer of interest rates between two agencies. It is a forward contract that enables two parties to interchange their interest rate from fixed to floating or floating to fixed to mitigate fluctuations in interest rates on borrowings. These swaps are utilized to avoid interest rate risk.

Types of interest rate swaps: The following are the types of interest rate swaps:

Fixed to floating: Under fixed to floating swaps, borrowers can exchange their fixed interest rate cash flow with the floating interest rate of another party if the borrower believes that the floating rate will charge lower cash flow than the fixed interest rate. If the borrower wants to receive floating interest payments, then the borrower can enter into an interest rate swap with another party that is looking forward to receiving fixed interest payments.

Floating to fixed: Under floating tp fixed swaps, borrowers can exchange their floating interest rate cash flow with the fixed interest rate of another party if the borrower believes that the fixed rate would yield higher cash flow than the floating interest rate. If a borrower wants a fixed rate of interest but he gets a floating rate of interest, then the borrower can enter into interest rate swaps with another party that is looking forward to receiving floating interest payment.

Floating to floating: Borrowers often enter into swap contracts to exchange their lifetime of repayments. They can enter into interest rate swaps and exchange their floating interest rate with other floating rate borrowings to equal their payments at the maturity period.

Commodity swaps

Commodity swaps are derivatives in which two parties agreed to exchange their cash flows of the specified assets or commodity up to a defined period of time. Generally, commodity swaps are utilized to secure the price against the cost variance of commodities in the market. Commodity swaps enable consumers and sellers in the market to decide the cost for the given commodity to avoid price changes. Commodity swaps are generally used for the items oil, metals, and livestock.

Types of commodity swaps

• Fixed to floating
• Commodity for interest

Equity swaps

Equity swaps are an arrangement in which two parties are agreed to exchange equity-based cash flows for fixed cash flows for a particular period. Equity swaps are like interest rate swaps. Security holders use equity swaps to hedge the loss against falling security prices without the involvement of the transfer of shares.

For example, if an investor X wants to depict the return of JK company’s share without buying the shares in the market. At the same time, Y who is holding the shares of company JK wanted to transfer his shares for the short term. Because he hopes that in the market, the share price of JK will fall down. In this situation, X and Y can enter into an equity swap agreement to swap their shares.

Types of equity swaps

• Fixed-rate
• Floating-rate
• Equity return

Currency swaps

Currency swaps are derivatives that are utilized to trade the principal amount and interest in one currency for another currency. Currency swaps are used to hedge the foreign exchange risks. Organizations having branches and operations in other countries use currency swaps to acquire favorable rate finance or loan from their home country. Currency swaps are also called cross-currency swaps. Currency swaps include two types of swaps.

Types of currency swaps

• Fixed to fixed
• Fixed to floating

Credit default swaps

A credit default swap is a derivative that provides protection to the customer against the risk of default and other risks. In a credit default swap, the purchaser gives cash to the issuer till the specified time limit. The issuer of the credit default swap will reimburse the purchaser, during the default or any other loss.

Total return swaps

A total return swap is an arrangement between agencies to exchange the income from financial assets. In this swap, one party makes payment confirming the determined price in the agreement. Another party will pay confirming the earnings from the assets.

Advantages of swaps

Minimizes the cost of transactions

Swap contracts are inexpensive because swap transactions do not require a premium amount at the time of initiation of the contract. It minimizes the cost of transactions.

Provides flexibility

Swap contracts provide flexibility to parties in the contracts. Swap contracts are not systemized contracts as the terms and conditions of the contract are decided by the parties themselves.

Used to hedge fluctuation losses and expenses

Swap contracts are used to hedge fluctuation risks and losses. Trading in swaps helps to mitigate interest rate fluctuation, exchange rate fluctuation, and financial losses.

Provides long-term benefits

Swap contracts are long-term contracts. Trading in swaps provides longer-term benefits than other financial derivatives such as futures, options, and forward contracts.

Assists in the foreign exchange market

Investors and traders in the foreign exchange market use swap contracts to hedge currency rate fluctuations. Swap derivatives support major currencies such as dollars and euros in foreign exchange transactions.

Disadvantages of swaps

Termination cost

Swaps are long-term contracts. If any party to the contract terminates the swap contract before the due date, they should be liable to pay a penalty for termination.

Liquidity

Liquidity benefits are not available in swap trading as swap contracts are long-term contracts.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for

• Bachelors of Commerce
• Master of Commerce
• Chartered Financial Analyst
• Certified Public Accountant

Practice Problems

Question 1: Which one is the type of swap?

1. Interest rate swaps
2. Futures
3. Options

Answer: Option (a) is correct.

Explanation: Interest rate swap is the swap contract, which enables borrowers to exchange their interest rate on borrowings. Interchange their interest rate from fixed to floating or floating to fixed to mitigate fluctuations in interest rates on borrowings. These swaps are utilized to avoid interest rate risk.

Question 2: What are the vital currencies used in foreign exchanges?

1. Dollar
2. Euro
3. All of the above

Answer: Option (c) is correct.

Explanation: Widely used foreign currencies are the dollar and euro. The Euro to US dollar is a widely used currency pair in the forex market as these two currencies represent the world’s enormous economy.

Question 3: What are the types of commodity swaps?

1. Fixed to floating
2. Commodity for interest
3. All of the above

Answer: Option (c) is correct.

Explanation: Commodity swap includes two types of swaps. They are fixed to floating and commodity for interest.

Question 4: What are the advantages of swap?

1. Liquidity
2. Flexibility
3. All of the above

Answer: Option (b) is correct.

Explanation: Swap contracts provide flexibility to parties in the contracts. Swap contracts are not systemized contracts as the terms and conditions of the contract are decided by the parties themselves.

Question 5: What are the disadvantages of swaps?

1. Termination cost
2. Liquidity
3. All of the above

Answer: Option (c) is correct.

Explanation: Swaps are long-term contracts. If any party to the contract terminates the swap contract before the due date, they should be liable to pay a penalty for termination. Liquidity benefits are not available in swap contracts as swap contracts are long-term contracts.