Risk Management with Swaps

28/07/2020 1 By indiafreenotes

Swaps are used to manage risk in a couple ways. First, you can use swaps to ensure favorable cash flows, either through timing (as with the coupons on bonds) or through the types of assets being exchanged (as with foreign exchange swaps that ensure a corporation has the right type of currency). The exact nature of the risk being managed depends on the type of swap being used.

Four types of swaps are interest rate, currency, equity, and commodity swaps.

  • Interest rate swaps typically involve one side paying at a floating interest rate and the other paying at a fixed interest rate. In some cases both sides pay at a floating rate, but the floating rates are different.
  • Currency swaps are essentially interest rate swaps in which one set of payments is in one currency and the other is in another currency. The payments are in the form of interest payments; either set of payments can be fixed or floating, or both can be fixed or floating. With currency swaps, a source of uncertainty is the exchange rate so the payments can be fixed and still have uncertain value.
  • In equity swaps, at least one set of payments is determined by the course of a stock price or stock index.
  • In commodity swaps at least one set of payments is determined by the course of a commodity price, such as the price of oil or gold.

The easiest way to see how companies can use swaps to manage risks is to follow a simple example using interest-rate swaps, the most common form of swaps.

  1. Company A owns $1,000,000 in fixed rate bonds earning 5 percent annually, which is $50,000 in cash flows each year.
  2. Company A thinks interest rates will rise to 10 percent, which will yield $100,000 in annual cash flows ($50,000 more per year than their current bond holdings), but exchanging all $1,000,000 for bonds that will yield the higher rate would be too costly.
  3. Company A goes to a swap broker and exchanges not the bonds themselves but the company’s right to the future cash flows.

Company A agrees to give the swap broker the $50,000 in fixed rate annual cash flows, and in return, the swap broker gives the company the cash flows from variable rate bonds worth $1,000,000.

  1. Company A and the swap broker continue to exchange these cash flows over the life of the swap, which ends on a date determined at the time the contract is signed.

Revenue generation and swap derivatives

When pursuing opportunities to generate revenue through swaps, the process is no different, but the motivation behind the swap is to take advantage of differentials in the spot and anticipated future values related to the swap. To see how revenue generation works with swaps, consider the following example, which involves foreign exchange swaps, a simpler but less common form of swap (in the example, USD = U.S. dollar):

  1. Company A has USD 1,000 and believes that the Chinese Yuan (CNY) is set to increase in value compared to the USD.
  2. Company A gets in touch with Company B in China, which just happens to need USD for a short time to fund a capital investment in computers coming from the U.S.
  3. The two companies agree to swap currency at the current market exchange rate, which for this example, is USD 1 = CNY 1.

They swap USD 1,000 for CNY 1,000. The swap agreement states that they’ll exchange currencies back in one year at the forward rate (also USD 1 = CNY 1; it’s a very stable market in Example-World).

In the example, Company B needs the currency but doesn’t want to pay the transaction fees, while Company A is speculating on the change in exchange rate. If the CNY were to increase by 1 percent compared to the USD, then Company A would make a profit on the swap.

If the CNY were to decrease in value by 1 percent, then Company A would lose money on the swap. This potential for loss is why using derivatives to generate income is called speculating. (Did you know the term speculate means “to come by way of very loose interpretation” or “to guess”?)

Valuation of swap derivatives

The value of a swap isn’t very difficult to measure. Simply put, you start with the value of what you’re receiving plus any added value that results from changes in rates or returns and then subtract the value of what you’re giving away plus any increases in value associated with interest earned or changes in rates.

Of course, as with all known valuations, this is a hindsight calculation. When you’re estimating future value, the calculations involve the time value of money and the probabilities of event occurrences, both of which should be treated in the same manner as estimating the value of futures. Remember that a swap is nothing more than a combination of a spot rate exchange and a futures exchange in a single contract.