In finance, a swap is a derivative where to parties agree to temporarily exchange cash flow streams. Each cash flow stream is called a leg.
Swaps were developed for hedging purposes (risk mitigation) but are also bought and sold by speculators. Typically, at least one of the legs in a swap will be a cash flow stream that is highly affected by commodity price, foreign exchange rate or some other fluctuating variable that is difficult to predict.
Swaps are usually traded over-the-counter (OTC), but there are a few exchanges where swaps are bought and sold, notably the Chicago Mercantile Exchange, the Chicago Board Options Exchange, the Intercontinental Exchange and the Eurex AG. Swaps trades on exchanges are highly standardized, while swaps traded OTC are often tailor-made to suit the involved parties.
The details of the swap will be specified in the swap agreement. The swap agreement will, among other things, include information about how cash flows are accrued, how cash flows are calculated and the predetermined cash flow pay dates.
Interest rate swap
One of the most common swaps is the interest rate swap. With this type of swap, the two parties will typically use a bank as an intermediary.
Example: ABC Inc is paying interest on a loan with a fixed interest rate. CDE Inc is paying interest on a loan with a floating interest rate. CDE Inc dislikes having a floating interest rate. They want to know exactly what the interest rate will be for the coming 3 years. ABC Inc agrees to do a 3 year long interest rate swap with CDE Inc. They use a bank as an intermediary.
An amortizing swap is an interest rate swap where the notional principal for the interest payments will decrease during the lifetime of the swap.
Total return swap
A total return swap is a swap where one party commits to pay the total return of an asset while the other party commits to make periodic interest payment.
In this case, the total return of an asset is the capital gain or loss + any interest or dividend payments.
Currency swaps come in many different forms. A common one is the one where the principal and fixed rate interest payments for one loan is swapped for the principal and fixed rate interest payments on another (equally sized) loan in another currency.
Credit default swaps (CDS)
A credit default swap is a type of credit derivative contract. It is used when one party wish to transfer its credit exposure of a fixed income product to another party.
Example: ABC Inc purchases a CDS from XYZ Inc. ABC Inc commits to make payments to XYZ Inc until the swap contract reaches it maturity date. In exchange, the XYZ Inc assumes responsibility for a loan that a third party has been given by ABC Inc. If the third party defaults* on their loan (i.e. doesn’t pay it back to ABC Inc), XYZ Inc must pay back that loan to ABC Inc.
By purchasing this swap, ABC Inc has mitigated the risk of having the third party default on their loan. In a way, they have gotten “default insurance” since they know that XYZ Inc must pick up the bill if the third party defaults.
*Some CDS contracts have other requirements than default. The requirement can for instance be that the credit rating of the third party borrower falls below a certain level or that the third party borrower files for bankruptcy.
Subordinated risk swaps / Equity risk swaps
Companies and other legal entities will typically have legal risks, including management risk and other liabilities. Something can happen that forces the company to pay compensation to an injured party.
A subordinated risk swap / equity risk swap can be used to mitigate general or special entrepreneurial risks by transferring them to another party. The buyer of the swap contract pays to have risk transferred to the seller (writer).
Subordinated risk swaps / equity risk swaps are still uncommon and non-standardized.
Commodity swaps are used for a wide assortment of different commodities. A floating price, market price or spot price is exchanged for a fixed price over a pre-specified period of time.
Forward swap / Delayed start swap / Deferred start swap
This is an amalgamation of two swaps with different lifetimes. Sometimes, a forward swap / delayed start swap / deferred start swap is the best way to accommodate for the time-frame needs of one of the swap counterparts.
A swaption is not a swap, but an option on a swap. If you are the holder of a swaption, you have the right but not the obligation to enter into a specific swap. In some cases, you can only exercise your swaption on the expiry date. In other cases, you can exercise your swaption on any date until the expiry date of the swaption.