A swap is a derivative in which two parties switch cash flows of one’s financial instrument with those of the other party’s financial instrument. There are different types of swaps, some of which we are going to discuss today.
Zero Coupon swap
Zero Coupon swap involves an exchange of cash flows in which the stream of floating interest-rate payments is made periodically, but the stream of fixed-rate payments is made as one lump-sum when the swap reaches maturity instead of spanning over the life of the swap. The amount of the fixed-rate payment is based on the swap’s zero coupon rates. This kind of swap is used in those entities which have their debts denominated in floating rates, but consecutively would like to conserve cash for operational purposes. There can be various modifications in the swap agreement like a reverse zero-coupon swap that pays the lump-sum payment when the contract is initiated, reducing credit risk for the pay-floating party.
Zero coupon swaps are used by:
- Corporates to hedge a loan or issue whereby the interest is capitalized and paid at maturity.
- Banks used it as hedging instrument (either in bond issuance or corporate hedging) for customers.
- Investors because the rate of return is assured as this is the zero coupon rate. This is not true of a vanilla swap which has a yield or YTM (yield to maturity) because YTM is calculated assuming all coupons are reinvested at the YTM rate. And there is no assurance that this will be the case.
Asset Swap
An asset swap has similar in composition to a plain vanilla swap; the key difference is the underlying of the swap contract. Rather than regular fixed & floating loan interest rates being swapped, fixed & floating investments are being exchanged. Meanwhile, for a cross currency asset swap, the principal cash flow may also be swapped. In a typical asset swap, a merchant buys a bond from a consumer at the market price and sells the buyer a floating rate note at par. The dealer then enters into a fixed-for-floating swap with another counterparty to offset the floating rate obligation & the bond cash flows. For the premium bond, the dealer pays the customer the difference of the bond price and its par. For a discount bond, the customer pays the dealer the difference between the par & bond price. In the swap with a counterparty, the dealer pays a fixed bond coupon & receives LIBOR + a spread. The range can be determined from the cash that the dealer pays or receives and from the difference of the bond coupon & the par swap rate. The bond redemption value is used for the exchange of the principal at the time of maturity, the present value of the difference between the bond redemption value and its par value also adds to the spread.
Commodity swap
A commodity swap is an agreement in which exchanged cash flows are dependent on the price of an underlying commodity traded for a fixed price over a specified period. It is used as a hedging instrument to hedge the price of the commodity. The commodity in which this kind of swap generally takes place is oil. So, for example, a business that consumes a lot of oil might use a commodity swap to protect the maximum price for oil. In return, the company receives payments which are based on the market price.
On the other hand, if the producer of oil wants to fix its income, then it would accept to pay the market price to a financial institution in return for receiving fixed payments for the commodity. This kind of swap is similar to a Fixed-Floating Interest rate swap. The only difference is that in an Interest rate swap the floating leg is based on standard Interest rates such as LIBOR, EURIBOR, etc. but in a commodity swap the floating leg is based on the value of an underlying commodity like Oil, Sugar, etc. It is to be noted that there is no exchange of commodities during the trade.
Constant Maturity Swap (CMS)
A constant maturity swap is a swap agreement that allows the purchaser to fix the duration of cash flows on a swap. In this, the floating interest portion is resettled periodically by a fixed maturity market rate of a commodity with a duration extending beyond that of the swap’s reset period. The floating leg of the constant maturity swap is set against a point on the swap curve periodically. In it, the interest rate on one leg is reset regularly, but concerning a market swap rate rather than the LIBOR. The other leg of the swap is usually LIBOR, but it may be a fixed rate or possibly another constant maturity rate. Hence, the prime factor for a consistent maturity swap is the shape of the forward implied yield curves. This type of swap arrangement is exposed to changes in long-term interest rate movements. They are initially priced to reflect fixed-rate products with maturities between two and five years in duration but adjusted on each reset period.
The constant maturity rate swap period is longer than the yield on the financial instrument that the swap is reset to. For this reason, investors are susceptible to market changes for a longer period. Common investors interested in constant maturity swaps include large corporations and financial institutions looking for higher yields and diversified funding and life insurance companies looking to cover long-range insurance payouts. This swap differs from standard interest rate swaps in the sense that how the investments return is calculated. Unlike a standard interest rate swap, the floating leg of a constant maturity swap is periodically reset against a fixed instrument rate, such as a bond or stock.
A correlation swap
A correlation swap is an especially complicated form of financial derivative that enables one to contemplate on or hedge risks associated with the noted average correlation, of a collection of underlying products, where each product has periodically noted prices, as with commodities, interest rate, exchange rate, or stock index. It is not based immediately on the value of an underlying asset. Rather, it is based on the relationship between the value of two or more assets. Because of this, a correlation swap must be arranged privately and is not available through financial security exchanges. The correlation swap is based on the relationship between two assets on a future date, not the price.
Credit Default Swap
A credit default swap is an agreement that protects against future credit loss on a reference entity as a result of a particular credit event. A specific credit event is usually a default or possibly a credit downgrade of the entity or individual. The reference entity may be a bond, a name, a trade receivable a loan, or some other type of liability. The client of a default swap pays a premium to the writer or seller in exchange for the right to receive payment should a credit event occur. In short, the buyer is purchasing insurance against credit default of a party. A buyer of a CDS might be speculating on the possibility that the third party will indeed default. In return, the merchant agrees to pay off a third party debt if this party defaults on the loan. In this process, the risk of default is shifted from the holder of the fixed income security to the seller of the swap.
Example, suppose John holds a 10-year bond issued by company XYZ with a coupon interest amount of $100 each year. John is apprehended that XYZ will default on its bond payment. Bob enters into a CDS with Smith and agrees to pay him income payments of $50 (similar to an insurance premium) each year. In return, Smith agrees to pay Bob the $1,000 par value of the bond in addition to any remaining interest on the bond. If XYZ fulfills its obligation on the bond through maturity after ten years, Smith will make a profit on the annual $50 payments.
Trigger Swap
A Trigger Swap which allows one of the counterparties to lock in the spread between two different points on a particular yield curve. It is similar to an interest rate swap in which payments are squared off out if the benchmark rate is above a given trigger rate. In other words, it is an agreement under which the fixed rate payer receives the higher of the benchmark floating rate minus an agreed spread or a specified fixed rate. For a periodic trigger swap, the exchange of payments depends on the benchmark rate positioned for that particular period. If the benchmark rate is greater than the trigger rate, the fixed and floating payments are knocked out. If the benchmark rate is below the trigger rate in a subsequent period, regular fixed and floating payments are made. For a permanent trigger swap, if the fixed and floating payments are squared off out for a particular period, then all subsequent payments are also squared out as well. It is also called a curve-lock swap a subsidized swap, or a barrier swap.
Total Return Swap
A total return swap (TRS) is an agreement in which one party pays out the total return of a named asset, including any capital appreciation or depreciation and interest payment, in return receives floating cash flow or a regular fixed. Typical examples of assets of total return swaps are loans, corporate bonds, and equities. A total return swap can be resolved at the terminating date only or periodically, e.g., bi-annually. In this type of swap arrangement, the party receiving the total return will receive any income generated by the asset as well as a benefit if the price of the asset appreciates over the life of the swap agreement. The receiver must pay the owner an agreed rate throughout the swap. If the value of the assets declines over the swap’s course, the total return receiver will be required to settle the asset owner the number by which the asset has fallen in price.
Inflation Swap
An inflation swap is a derivative that is used to transfer inflation risk from one party to another by an exchange of cash flows. In this type of swap arrangement, one party pays a fixed rate on a notional principal amount, while the counterparty pays a floating rate linked to an inflation index, such as the Consumer Price Index (CPI) or Wholesale price index (WPI). The party paying the floating rate pays the inflation-adjusted rate multiplied by the notional principal amount. For example, one party may pay a fixed rate of 3% on a two-year inflation swap, and in return, receive the amount which is benchmarked with actual inflation. This swap arrangement helps to hedge the inflation risk.
Forex swap (FS)
A forex swap is a swap which involves a simultaneous purchase and sale of identical amounts of one currency for another currency with two distinct value dates like the spot to forward dates. Forex Swap allows sums of a certain currency to be used to support charges designated in another currency without earning foreign exchange risk. It allows companies that have funds in various currencies to manage them efficiently.
A forex swap consists of two legs:
- A spot foreign exchange transaction.
- A forward foreign exchange transaction.
The two legs are executed simultaneously for the same quantity and therefore offset each other
The relationship between forward and the spot is known as the interest rate parity.
where
F = forward rate
S = spot rate
rd = simple interest rate of the term currency
rf = simple interest rate of the base currency
T= Time
Equity Swap
An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counter-parties at set dates in the future. One leg of the equity swap is secured to a floating rate such as LIBOR or is established as a fixed rate. The cash flows on the other leg are correlated to the returns from a stock or a stock index. The leg associated with the stock or the stock index is referred to as the equity leg of the swap. Most equity swaps comprise of a floating leg vs. equity leg, although there may exist with two equity legs. An equity swap includes a notional principal, predetermined payment intervals and a specified tenor.
Dividend swap
A dividend swap is a derivative contract which consists of a series of payments made between two parties at the defined period over a fixed term. One party in a contract will pay the opposite party a prefixed payment at each interval, and the other party will pay its counterparty the total dividends that were paid out which can be a single company or a group of companies. The payments are multiplied with a notional number of shares. Similar to most swaps, the contract is usually arranged such that its value at the time of signing is zero. This is achieved by making the value of the fixed leg the same as the price of the floating leg. In simpler terms, the fixed leg will be the same as the average expected dividends throughout the swap. Hence the fixed leg of the swap can be used to determine market predictions of the dividends that will be given out by the underlying.