A swap is a deal in which two parties decide to exchange a prearranged sequence of payments over a period.
There are four normal structures which describe the most basic swaps, and which typically form the structure for very complex ones.
Interest Rate Swaps
An interest rate swap is an agreement between two parties to exchange fixed interest rate payments for floating interest rate payments.
The swap could be used to change the type of current liabilities or assets. For instance, to transform fixed-rate debt to floating-rate debt.
The payments would most probably be in the same currency on a particular notional amount.
In most of the fixed/floating interest rate swaps, the LIBOR floating rate is used, though other interest rates like the Treasury bill, Federal funds rate, prime rate, and the US commercial paper are sometimes used.
Basic swaps (floating swaps) could be considered a subgroup of interest rate swaps. In this, floating-rate interest payments estimated on a distinct basis are swapped for floating-rate payments in the same currency estimated on a different basis.
A currency swap is an agreement to exchange payments designated in one currency for those designated in another currency.
As far as the foreign exchange market is concerned, the term “swap” is used to refer to a spot sale and forward purchase of a currency, while in the capital markets a swap denotes to the exchange of interest payments and principal designated in one currency for payments in one more currency.
Currency swaps can be further divided into a fixed/fixed currency swaps and fixed/floating currency swaps.
Fixed/Fixed Currency Swaps
Fixed interest payments which occur in a particular currency are exchanged for fixed interest payments in an alternate currency. There has been usually an eventual exchange of principal and at times a preliminary exchange of principal.
Cross-Currency Interest Rate Swaps
This kind of swap is an amalgamation of a currency swap and an interest rate swap. The framework of the deal is similar to that of a fixed/fixed currency swap, the difference being that one or both groups of interest payments are on a floating-rate basis.
Again, similar to a fixed/fixed currency swaps there is an ending exchange of principal at the spot exchange rate prevailing when the deal was finalized.
Normally, swaps were used to change the currency or interest structure of liabilities. They have also been used to change assets. Asset swaps usually integrate an asset and a swap. Therefore, a fixed-rate asset could be altered into a floating-rate asset in either the same or another currency.
The market functions by leveraging price limitations in the bond market and the swap market.
The major part of the market is concerned with the development of synthetic FRNs. The purchasers of synthetic assets consist of commercial banks looking for high-yielding assets as a substitute to traditional loans, portfolio managers, and institutional fund managers.
Buyers could either purchase the bond and organize a distinct swap themselves or else purchase a package of a bond and the swap from an intermediary (investment/merchant/commercial banks having a presence in the secondary bond market).
The risks impacting those involved in swap functions depend on their specific role in the swap market. For instance, as far as a broker is concerned, once the fee is received, there is no further risk.
There is another risk called the position risk. It is the risk that interest rates and exchange rates shift negatively after the deal has been finalised.
Losses could occur either if interest and exchange rates fluctuate adversely, thereby resulting in a position loss or if rates move positively, thereby resulting in a position gain.
The three key features of position risk are:
- Position risk fluctuates over the tenure of the deal in line with changes in interest rates and/or exchange rates.
- It could either by positive or negative.
- It cannot be identified beforehand.
Another type of credit risk happens when the regularity of payments on the two sides of the swap varies.
The intermediary bank, which manages a swap faces further risks, the most critical being the spread risk (the risk that the spread between the swap price and the hedge price could vary). It is not easy to hedge against spread risk.
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