Swaps Contracts Meaning & Definition, Types

In finance, a swap is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.

The general swap can also be seen as a series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap. The legs can be almost anything but usually one leg involves cash flows based on a notional principal amount that both parties agree to. This principal usually does not change hands during or at the end of the swap; this is contrary to a future, a forward or an option.

In practice one leg is generally fixed while the other is variable,that is determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price.

Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps.

Types

Modern financial markets employ a wide selection of such derivatives, suitable for different purposes. The most popular types include:

Interest rate swap

Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.

Currency swap

Counterparties exchange the principal amount and interest payments denominated in different currencies. These contracts swaps are often used to hedge another investment position against currency exchange rate fluctuations.

Commodity swap

These derivatives are designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.

Debt-Equity Swaps

Debt or equity swaps act as a refinancing deal that involves the exchange of debt for equity. In this swap, the debt holder gets an equity position for the cancellation of the debt. It paves a way for struggling companies to relocate their capital structure. Since such companies can’t pay off their debts, they opt to get involved in debt-equity swaps to delay the payment. While some debt holders have to agree to this swap due to bankruptcy, others do have a choice in the matter as some companies engage in debt-equity swaps to reap the benefits of the favourable market conditions. The covenants in the bond indenture may oppose and prevent the swap without consent. For instance, businesses often offer attractive trade ratios like 1:2 wherein the bondholder receives stocks worth twice the value of his bonds, which makes the trade more enticing.

Credit default swap

A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps became somewhat notorious due to their impact on the 2008 Global Financial Crisis.

In CDS, both the parties get into an agreement in which the one pays the lost principal and interest of a loan to the CDS buyer in case a borrower defaults on the loan. CDS swap was one of the major contributing factors in the 2008 financial crisis along with poor risk management and excessive leverage as the investors offset their credit risk with that of another investor. The majority of the CDS contracts are maintained via an ongoing premium payment (which is quite similar to the regular premiums due on an insurance policy) and usually involve mortgage-backed securities or municipal and corporate bonds.

Total Return Swaps

In total return swaps, the overall returns from an asset are traded for a fixed (or variable) interest rate. This exposes the party that is paying the fixed rate to the underlying asset which is usually a stock, bond or index. Hence the second party can reap benefits from this asset without actually owning it. The parties involved in this swap are called total return payer and total return receiver.