What is Swaps?
In case of forwards, futures and options, a particular quantity of specified assets are to be exchanged for a specified cash payment. But in case of swap, cash flow is to be exchanged for cash flow. One company may be paying fixed rate of interest on loan. But it prefers floating rate. Another company may be paying a floating rate. But it prefers fixed rate. So it is sensible for both companies to enter into a swap agreement. Swap allows a borrower to exchange his liability with another type of liability.
Meaning of Swaps
Swap literally means exchange t refers to exchange a thing in return for another it is an agreement between two parties to exchange a series of cash flows over a period in the future. Swap is an agreement to exchange one stream of cash flow for another in future. These two streams of cash flows may be called two legs of a swap contract. The basic idea behind swaps is that the parties involved get access to markets at better terms than would be available to each one of them individually. The gains achieved by the parties are divided amongst them depending on their relative competitive advantage.
Financial swap is a specific fund technique which permits a borrower to access one market and then exchange the liability for another type of liability. Thus, under a swap contract future cash flows are traded over a period of time. In short, swap is an agreement between two parties in order to trade future cash flows.
Even though swaps are used for various purposes (from hedging to speculation), their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability. For example, an investor realising returns from an equity investment can swap those returns into less risky fixed income cash flows, without having to liquidate the equities. A company with floating rate debt can swap that debt into a fixed rate obligation, without having to retire and reissue debt. A swap is a cash-settled OTC derivative.
There is another derivative known as switch. Switch is similar to swap. Switch is not an
exchange of security for cash but an exchange of one security for another both in the spot market.
Features of Swaps
Swap is a combination of forwards by two counter parties. It is arranged to get the
benefits arising from fluctuations in the market.
The following are the significant features of a swap:
- A swap is nothing but a combination of forwards. So it has all the properties of forward contracts.
- Swap requires that two parties with equal and opposite needs must come into contact with each other.
- Swap deals are customised, tailor-made and OTC derivatives.
- It is in the nature of long-term agreement. It is just like long dated forward contract.
- Swap agreements are arranged mostly through an intermediary. This intermediary isknown as swap facilitator. Generally the role of intermediary is played by large international financial institutions or banks.
- Most of the swap deals are bilateral agreements. Therefore, there is a problem of potentialdefault by either of the counter-party. This makes swaps more risky.
- Swaps do not involve an upfront payment. Thus, they have a zero value at the start.
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