An Introduction to Swap Agreements

What are Swap Agreements?

 A swap agreement is an agreement between two parties to exchange financial instruments or cash flows for a certain period of time. Here the financial instruments can be almost anything but most of the swaps involves cash based on a notional principal amount i.e. the face value on which the payments calculation on a financial instrument are determined.

First Introduced: Swaps were initially introduced to the general public in the year 1981 when the World Bank and the IBM entered into a swap agreement. Today, swaps are amongst the most heavily traded financial contracts in the world.

Purpose of Swaps:

Swaps are primarily over-the-counter contracts between parties i.e. directly traded between two parties without going through an exchange or other intermediary. 

They are mostly used to –

• Switching financing in one country for financing in another country.
• To replace a fixed interest rate swap with a floating interest rate or vice versa.

Types of Swaps:

There are many types of swaps, here are the most generic types of swaps are as follows:

 An interest rate swap is a financial contract between two parties that want to exchange interest rates. These could be interest rates  they’re paying on loans or rates they are  receiving on investments. In order to reduce or increase exposure to fluctuations in interest rates, these swaps can be fixed or floating rate. Most interest rate swap users are banks, corporations and investors. Even governments  also use this swap.

2). Currency swaps –

A currency swap involves exchanging of notional principal and fixed rate interest payments on a loan in one currency for principal and the fixed rate interest payments on an equal loan in another currency. Currency swaps can take place in different countries, for eg, in 2018 India and Japan signed a bilateral currency swap agreement that aids in bringing greater stability to foreign exchange and capital markets in India.

3). Commodity Swap: 

A commodity swap is an agreement where a market price or floating price or spot price or market price is exchanged for a fixed price over a specified period. The vast majority of this kind of swap involves crude oil.

4). Credit Default Swap:

 

Credit default swap comprises an agreement by a single party to pay the principal amount that is lost as well as the interest on a loan to the credit default swap buyer, provided that the borrower defaults on their loan.

 

5). Equity Swap:

Equity swap agreements are to exchange future cash flows between the two parties where one leg is typically a fixed-income cash flow and other leg is an equity-based cash flow.

6). Inflation Swaps:

An inflation-linked swap is when one party pays off a fixed rate cash flow on a certain notional principal amount and the other party pays a floating rate linked to an inflation index, such as CPI (Consumer Price Index). The primary objective of this kind of swap is to hedge against inflation and interest rate risk.

Exiting a Swap Agreement:

Sometimes its seen that one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is just similar to an investor selling exchange-traded contracts before expiration. There are four basic ways to do exit a swap agreement –

• Buy out the counterparty

• Enter an offsetting swap

• Sell the swap to someone else

• Use a swaption.

Advantages of Swaps:

✓ Swap is generally cheaper and reduces transactions costs.

✓ Swap can be used to hedge risk.

✓ It provides flexibility and maintains informational advantages.

✓ It has longer term than futures, forwards or other.

✓ Swap gives companies a better match between their liabilities and revenues.

✓ Provides access to new financial markets for funds by exploring the comparative advantage possessed by the other party in that market.

✓ Financial intermediaries can also earns additional income in the form of brokerage by arranging swaps.

Disadvantages of Swaps:

• Early termination of swap before the maturity may incur a breakage cost.

• Lack of liquidity.

• Subject to default risk.