This article is written like a personal reflection or opinion essay that states a Wikipedia editor’s personal feelings about a topic. This article needs attention from an expert in Business and Economics. Please add a reason or a talk parameter to this template to explain price return swap investopedia forex issue with the article. A swap is a derivative contract where two parties exchange financial instruments.
The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange, the largest U. At the end of 2006, this was USD 415.
The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid-2008. As the International Finance in Practice box suggests, the market for currency swaps developed first. Today, however, the interest rate swap market is larger.
Size is measured by notional principal, a reference amount of principal for determining interest payments. The exhibit indicates that both markets have grown significantly since 2000, but that the growth in interest rate swap has been by far more dramatic. A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. The 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 five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps.
There are also many other types of swaps. A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can ‘swap’ their existing obligation for their desired obligation.
Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments. 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. 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. Party A in return makes periodic interest payments based on a fixed rate of 8. The payments are calculated over the notional amount. 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. The vast majority of commodity swaps involve crude oil. There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures. A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments.
Note that if the total return is negative, then party A receives this amount from party B. An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap. A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.
An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes. A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future. An Accrediting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.
A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative. While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market.