SWAP A FINANCIAL DERIVATIVE

By:V.M.Prasad

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement

A swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument

Example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest payments associated with the bonds

Two counterparties Swap agreement defines the dates

when the cash flows are to be paid and the way they are calculated

Cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices

Types of swaps

Interest rate swaps Currency swaps Commodity swaps Credit default swaps Forward swap Total return swap Circus swap Roller coaster swap Airbag swap

Interest rate swaps It is the exchange of a fixed rate loan to a

floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets

Currency swaps Exchanging principal and fixed rate interest

payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.

Commodity swaps A commodity swap is an agreement whereby a

floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil

Credit default swaps Contract in which the buyer of the CDS makes a

series of payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond or loan - goes into default (fails to pay)

Forward swap Swap agreement that is often valued with two

different and partial offsetting swaps and both the swaps starts immediately. But one of them ends on the date of the start of the other one known as forward swap. This swap is specially designed for the timing convenience of the investors.

Total return swap Agreement that allows one party to pay

according to a fixed rate or according to a variable rate. But, the other party only pays according to the returns it gets from the underlying assets like loans, bonds, etc. and includes the generated income from and the capital gains of the underlying assts.

Circus swap Cross-currency swap and includes the

characteristics of both the currency swap as well as of the interest rate swap. Under this swap a loan of fixed rate of a particular currency can be replaced with a loan of floating rate of some other currency.

Roller coaster swap It is a kind of seasonal swap that gets created for

meeting the periodical financial requirements of the counter-party and provides some liberty in terms of payment according to the periods set beforehand. So if a company is dealing in some commodity, which has its demand seasonally, then the company will surely go for a roller coaster swap

Airbag swap This swap gets created to counter the effects of

fluctuating interest rates that puts a negative pressure on the investment. This counter effect is achieved through the adjustment of the notional value of the fluctuating interest rate by indexing the very part of the interest rate that is fluctuating to a constant maturity swap.

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