Swaps and Its Types
Investing in Stock Market Notes
Meaning of Swap
A Swap is an agreement between two parties to exchange one set of cash flows for another which is calculated according to a predefined formula. A swap is nothing but a barter or exchange but it plays a very important role in international finance.
Usually, when the swap contract is formed at least one of these series of cash flows is determined by a random or uncertain value like interest rate or equity price etc. Most swap contracts are traded OTC which are tailor made for the counterparties. Some are also traded in organized exchanges.
Types of Swap
The five generic types of swaps are:
1. Interest Rate Swaps:
In Interest rate swaps, each party agrees to pay either a fixed or a floating rate in a particular currency to the other party. The fixed or floating rate is multiplied with the Notional Principal Amount (NPA) say Rs. 1 lac. This notional amount is not exchanged between the parties involved in the Swap. This NPA is used only to calculate the interest flow between the two parties.
The most common interest rate swap is where one party ‘A’ pays a fixed rate to the other party ‘B’ while receiving a floating rate which is pegged to a reference rate like LIBOR. (LIBOR – London Inter Bank Offer Rate)
For e.g., a Swap arrangement between two people could be like, ‘A’ pays a fixed rate of 3% to ‘B’ on a principal of Rs. 1 lac every month and ‘B’ in turn would pay ‘A’ at the rate of LIBOR + 0.5%. The cash flow that ‘B’ can expect from ‘A’ is fixed whereas the value that ‘A’ would receive would vary based upon the LIBOR. If the LIBOR that month is 2% then ‘A’ would receive an interest of 2.5% that month. The fixed rate of 3% is termed as the ‘Swap Rate’.
At the point of Initiation of the Swaps the swap is priced in such a way that the “Net Present Value” is ‘0’. If one party wants to pay 50 bps (Basis points or 0.5%) above the Swap rate, then the other party may have to pay the same 50 bps above LIBOR.
Net Present Value – NPV is defined as the total present value of a series of cash flows. The term NPV is used widely in the financial terms and it is used by people to decide on whether to invest in an instrument or not.
2. Currency Swaps:
A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.
Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.
A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.
3. Equity Swaps:
An Equity Swap is a special type of swap where the underlying asset is a stock or a group of stocks or even a stock market index. The key differentiator in equity swaps is the fact that the floating leg of the payment is dependent on the performance of the underlying stock. One party would receive fixed amounts regularly while the other would receive a payment depending on the performance of the Stock upon which the Equity swap is created.
4. Commodity Swaps:
In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow. Commodity swaps are used for hedging against Fluctuations in commodity prices or Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)
A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.