Together with futures, forwards, and options, a swap is a type of a derivative financial instrument.
What Is a Swap?
It is the trade and financial operation in the form of exchange of various assets. During a swap, an agreement on the purchase (sale) of securities or currencies is accompanied by a counter-agreement. i.e. the return sale (purchase) of the same product after a certain period of time on the same or other conditions. In particular, two parties agree to exchange one cash flow against another. The swap agreement determines the dates when the cash flows are to be paid and the way they are accrued and calculated.
Types of Swaps
There are the following forms of swaps:
This is an agreement between the two parties that on a certain date one party will pay the other party a fixed interest for a certain amount. In return, they will receive a payment for the interest amount at a floating rate from the second party. In fact, it is an agreement to replace one form of interest payments with another. Interest swaps are typically used to hedge transactions with assets and liabilities for the mutual transfer of fixed rates to floating and vice versa. Interest swaps are very popular and highly liquid instruments that can be used for speculative operations.
This is a combination of two opposite conversion transactions for the same amount with different value dates. In the case of a swap, the execution date of the nearest transaction is called the value date. The execution date of the reverse transaction that occurs later is called the maturity date. Most currency swap transactions are concluded for a period of up to 1 year.
If the first transaction refers to the purchase of a currency, and the second one (reverse) refers to the sale of a currency, such a swap is called a buy and sell. If in the beginning, a sales transaction is carried out, and the reverse transaction is the purchase of currency, this swap will be called a sell and buy swap.
As a rule, a currency swap transaction is conducted with one counterparty, that is, both conversion operations are carried out with the same bank. This is the so-called pure swap. However, it is possible to combine two opposite conversion transactions with different valuation dates for the same amount concluded with different banks - this is an engineered swap.
A stock swap occurs during the acquisition of business when the acquiring company uses its own shares to pay for the acquired company. Each shareholder of the newly acquired company receives a specific number of the acquirer's shares in exchange for the shares that they owned in the acquired company. Sometimes the shareholders have to wait for a specified period of time before they are allowed to sell their new shares. Additionally, a stock swap is a way to exercise stock options where shares that the holder already owns are used to purchase new shares at the strike price.
This type of swap acts as an insurance against the counterparty's failure to meet financial obligations. Under the terms of the credit default swap (CDS) agreement, the buyer makes one-time or regular contributions (pays a premium) to the CDS seller. The seller, in their turn, undertakes to repay the loan issued by the buyer to a third party - the reference entity - in the case of a credit event. A credit event indicates that the reference entity cannot repay a loan, for example, by compulsory restructuring, declaration of a moratorium on payments, or bankruptcy.
The buyer gets the credit risk protection - a kind of insurance for a previously issued loan or a purchased debt obligation. In case of default, the buyer will transfer to the seller the reference entity, and in return will receive from the seller monetary compensation for the amount of the debt.
There are two forms of obligations under the CDS after the credit event occurs - cash compensation and physical delivery. The first form provides that the seller covers the buyer's loss in the amount of the difference between the nominal and real (current) of the obligations of the reference entity - the recovery value. In the case of physical delivery, the CDS seller is obliged to purchase from the buyer an asset specified in the agreement at a certain price, for example, its nominal value. Thus, the risk of an adverse change in the asset's credit quality passes to the seller.
It is the combination of a swap and an option. This agreement gives the buyer the right to conclude a swap transaction with agreed parameters such as the duration, frequency of settlements, and flat rate. Like other options, swaption grants the right to conclude a contract in the future with the terms now stipulated but does not oblige to do so. The fee reflects the variability of compliance with the agreed characteristics of the swap in the future.
There are the following types of swaptions:
Call - the buyer has the right pay at a fixed rate while being paid at a floating rate.
Put - the buyer has the right pay at a floating rate while being paid at a fixed rate.
Straddle - the buyer can choose to pay either at a fixed or floating rate in the future.
If a swaption buyer wants to purchase a fixed-rate asset (or currency) while simultaneously selling a similar asset at a floating rate, they can conclude a swaption call, thus transferring all risks to the seller. If for any reason the current floating rate is lower than the previously agreed fixed rate, the trader will incur losses. By taking advantage of the swaption, they will receive a fixed fee, which they will pay for their obligations, and they will give the floating rate to the seller. If the floating rate is higher than the fixed purchase price, then the trader will simply refuse to swaption because they will profit from such conditions.