Ebook- Certified investment banking

Introduction to swaps

It is an agreement between two counterparties to exchange financial instruments or cash flows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount

The general swap can also be seen as a series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap.

The legs can be almost anything but usually one leg involves cash flows based on a notional principal amount that both parties agree to. 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

Different types of 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
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
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 cash flows 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.
An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms. The primary objective is to hedge against inflation and interest-rate risk.
A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.
An agreement whereby the payer periodically pays premiums, sometimes also or only a one-off or initial premium, to the protection seller on a notional principal for a period of time so long as a specified credit event has not occurred.[22] The credit event can refer to a single asset or a basket of assets, usually debt obligations. 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. The primary objective of a CDS is to transfer one party’s credit exposure to another party.
A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.
An agreement to exchange future cash flows between two parties where one leg is an equity-based cash flow such as the performance of a stock asset, a basket of stocks or a stock index. The other leg is typically a fixed-income cash flow such as a benchmark interest rate.