Swap (finance)
For the Thoroughbred horse racing champion, see: Swaps (horse).
In finance, a swap is a derivative, where two counterparties exchange one stream of cash flows against another stream. These streams are called the legs'' of the swap. The cash flows are calculated over a
notional principal amount. Swaps are often used to
hedge certain risks, for instance
interest rate risk. Another use is
speculation.
 |
An illustration of a standard fixed/float interest rate swap |
Swaps are
over-the-counter (OTC) derivatives. This means that they are negotiated outside exchanges. They cannot be bought and sold like
securities or
futures contracts, but are all unique. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty.
The
Bank for International Settlements (BIS) publishes statistics on the
notional amounts outstanding in the OTC Derivatives market. At the end of 2004, this was USD 248.288 trillion (that is, USD 248,288 billion, or six times
World GDP). The majority of this (USD 147.4 trillion) were
interest rate swaps. These split by currency as:
>| Notional outstanding
in USD trillion |
| Currency | End 2000 | End 2001 | End 2002 | End 2003 | End 2004 |
| Euro | 16.6 | 20.9 | 31.5 | 44.7 | 59.3 |
| US dollar | 13.0 | 18.9 | 23.7 | 33.4 | 44.8 |
| 11.1 | 10.1 | 12.8 | 17.4 | 21.5 |
| Pound sterling | 4.0 | 5.0 | 6.2 | 7.9 | 11.6 |
| Swiss franc | 1.1 | 1.2 | 1.5 | 2.0 | 2.7 |
| Total | 48.8 | 58.9 | 79.2 | 111.2 | 147.4 |
:
Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1]'' Usually, at least one of the legs has a rate that is
variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any
conflict of interest. For instance,
LIBOR is set by the
British Bankers Association, an independent trade body.
Interest Rate swaps are the most common type of swap, also known as a 'plain vanilla' swap. They typically exchange fixed rate payments against floating rate payments. The principals are not exchanged, and are known as the notional principal. Exceptions exist, such as floating-to-floating swaps (known as
basis swaps).
A
total return swap is a swap, where 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. The parties have exposure to the return of the underlying stock or index, without having to hold the
underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.
Total return swap, or total rate of return swap, or TRORS, is a contract in which one party receives interest payments on a reference asset plus any capital gains and losses over the payment period, while the other receives a specified fixed or floating cash flow unrelated to the credit worthiness of the reference asset, especially where the payments are based on the same notional amount. The reference asset may be any asset, index, or basket of assets.
The TRORS, then, allows one party to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (which does retain that asset on its balance sheet) to buy protection against loss in its value.
The essential difference between a TRORS and a credit default swap is that the latter provides protection not against loss in asset value but against specific credit events. In a sense, a TRORS isn't a credit derivative at all, in the sense that a CDS is. A TRORS is funding-cost arbitrage.
[edit]UsersHedge funds in the market to see protection against asset value loss are generally doing so in order to take advantage of leverage.
Retrieved from "http://en.wikipedia.org/wiki/Total_return_swap"
An
equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.
The value of a swap is the
net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the
NPV of all future
cash flows is equal to zero.
For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the
fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the
expected future floating rate payments (i.e. the NPV is zero). Were this not the case, an
Arbitrageur, C, could: # assume the position with the
lower present value of payments, and borrow funds equal to this present value# meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value# use the received payments to repay the debt on the borrowed funds# pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.
See: Rational pricing; ArbitrageVariations of swaps include
cross currency swaps, amortizing swaps and so on.
An option on a swap is called a
swaption.
*
Credit default swap*
Cross currency swap*
Foreign exchange swap*
Constant maturity swap*
Yield curve*
swaps index, quantnotes.com
*
GE restate earnings because interest rate swaps didn't meet
SFAS 133 hedge accounting criteria
*
Bank for International Settlements
