- Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties.
- Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.
Interest Rate Swap
- The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than 15 times the size of the U.S. public equities market.
- The most common and simplest swap is a plain vanilla " interest rate" swap. Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods.
Example, on on December 31 2006, companies A and B enter into a 5 year swap with these terms:
Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million.
For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period.
At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On December 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount.
Currency Swap
- Other common type of swap is a currency swap. In this the nominal amounts are actually exchanged at the beginnig and end of the swap. Amounts payable may possibly be netted at the current exchange rate against each other - to reduce the 2 potential huge payments down to a single net payment which is the difference of the 2.
Example - Suppose a corporation needs an AUD 100MM loan, but US-based lenders are willing to offer more favorable terms on a USD loan. The corporation could take the USD loan and then find a third party willing to swap it into an equivalent AUD loan. In this manner, the firm would obtain its AUD loan but at more favorable terms than it would have obtained with a direct AUD loan.