What are Swaps in Derivatives & its Types?

Introduction

Swaps represent the newest category of Derivatives. Swaps were initially conceived as a method to avoid paying foreign currency exchange taxes by companies. The first such public agreement took place between IBM and World Bank in 1980, in which the former exchanged its stock of Swiss Francs and German Marks for the latter’s US Dollars. Swaps have also been widely implicated as a significant cause of the 2008 global economic crisis. Since then, Swaps have become more regulated, widely shifting from being traded on the Over Counter (OTC) markets to the Exchange Traded markets.

What are Swaps?

• Swaps are bilateral contracts in which the two parties agree to exchange revenue streams from two different sources for a predetermined period.
• Swaps are usually made and brokered by large banks and corporations. These institutions are known as market makers.
• Each revenue stream is called a leg.
• Traders use swaps for hedging. They can also gain access to new markets by swapping with investors from the new markets.

Types of Swaps

While the basic principle is the same in all Swaps, there exist many variations based on the asset being swapped:

• Interest Rate Swaps are bilateral contracts. The parties agree to exchange revenue streams from two different sources for a given period. It involves the swapping of a fixed interest rate with a floating interest rate.
• Currency Swaps are bilateral contracts in which the two parties interchange the underlying asset and its interest in one currency with the same in another currency. Currency Swaps are used to escape foreign currency exchange taxes and for protection against currency exchange rate fluctuations.
• Commodity Swaps are bilateral contracts in which the two parties exchange the market price of an underlying asset with a predetermined fixed price. Commodity Swaps generally involve crude oil. Investors use these as protection against commodity price fluctuations.
• Equity-Debt Swaps refer to bilateral agreements in which the debt holder gains an equity position in return for the cancellation of their debt. Equity-Debt Swaps are used by struggling companies as refinancing deals.
• Total Return Swaps refer to bilateral contracts in which the buyer, also called the receiver, collects all revenue generated by an underlying asset without owning it. In return, the buyer pays the seller a predetermined amount for the contract as the set rate of the underlying asset. Hedge funds prefer these Swaps as they provide greater asset exposure at a minimal cost.
• Inflation Swaps are bilateral contracts in which the two parties interchange the fixed-rate payoffs on a notional principal amount for the floating rate payoffs linked to inflation indices.
• Credit Default Swaps refers to bilateral agreements in which one party receives a fixed amount in return for compensating the other party if the default of the underlying assets. These are generally used to bail out companies and other institutions to keep them running.

Conclusion

While the versatility of Swaps makes them attractive to large companies, there has been growing concern about the role of these instruments in financial crisis and tax evasion. Such a situation has led to increased regulation, such as the Dodd-Frank Act of 2010 in the US, making these instruments more transparent for investors. Today, swaps have emerged as one of the favoured hedging instruments, but still, it has eluded the majority because of the risk associated with it.