A swap is an act of exchanging one thing for another. In finance, swaps are derivatives wherein two counterparties exchange financial instruments. The swaps can involve an exchange of a series of cash flows of one party’s financial instrument for those of the other party’s financial instrument over a specific period of time. Swaps are mutual agreements that are easy to design and customize over the counter. They offer great flexibility that leads to many swap variations with each serving a given purpose.
Reasons why parties agree to such arrangements:
If their investments or repayment objectives change
If it is beneficial financially to switch, to a new or alternative stream of cash flows compared to the existing ones
To hedge against risks such as mitigation risks associated with a floating rate loan repayment.
Here are the 5 common types of financial swaps:
1. Interest Rate Swap
This is the most popular type of swaps. An interest rate swap is a contract between two parties to exchange a stream of future interest payments based on the principal amount. The parties exchange floating interest rate for a fixed rate or vice versa to increase or reduce exposure to interest rates volatility to obtain a marginally lower rate than would have been possible without the swap. It can also involve the exchange of one floating rate for another and usually occurs only to change the type or tenor of the floating rate index usually called basis swap. It usually occurs if a company can obtain a loan easily at one type of interest rate but prefers a different type of rates.
2. Currency Swaps
Currency swaps involve the exchange of interest and in some cases of full exchange of principal amounts in one currency for the same but in another currency. It is also referred to as cross-currency swap as it involves foreign exchange transaction. It is a very flexible method of foreign exchange as maturities of the currency swaps are negotiable for at least 10 years. The interest rates can be floating or fixed and the exchange can be fixed vs. fixed, floating vs. floating and fixed vs. floating. The swap helps to hedge against interest rates and forex rates fluctuations for long-term investments.
3. Commodity Swaps
A commodity swap is a financial derivative agreement where two parties agree to exchange cash flows which are reliant on the underlying commodity price. This swap is most common among people who use raw materials to produce finished products. It is used to hedge against the price of a commodity. It consists of a floating-leg component and a fixed-leg component where the floating-leg component is attached to the market price of the underlying commodity or agreed upon commodity index and the fixed-leg component is specified in the contract. These swaps are settled in cash but the physical delivery is predetermined in the contract.
4. Credit Default Swaps
The credit default swap offers insurance in the event that third-party borrower defaults. It helps transfer between two or more parties the credit exposure of fixed income products. The swap buyer makes payment to the swap seller until the date of the maturity of the contract. The seller in return agrees that they will pay the buyer the security premiums in addition to all interest payments that would have been paid between that time and the security maturity date in the event that the debt issuer defaults.
5. Equity Swaps
An equity swap is a financial derivative contract where two counterparties agree to exchange a set of future cash flows at set date’s n the future. The two cash flows are known as legs of the swap. The legs of the swap include the floating leg which is pegged to a floating rate such as LIBOR and the other leg component is the equity leg which is based n the performance of either a share of stock or a stock market index. Equity swaps help avoid transaction costs such as tax, limitations on leverage and get around policy governing a particular type of investment that an institution can grasp.
Swaps can be designed and structured in different ways to meet the needs of all the parties as they are offered over the counter (OTC). However, they are unregulated and so every investor should fully understand the implications of the swap before they enter into the contract.