In simple terms, a swap meaning from its name is exchanging one item for another, like a barter trade. It is a type of derivative contract between two parties and involves exchanging pre-negotiated cash flows of two financial instruments. We refer to each stream of cash flow as a “leg.” The notional principal amount is what determines the cash flows. They are a relatively new type of derivative since they came into play in the late 1980s. They have extensive applications, thereby making them very popular in trading today. Unlike the other derivatives, futures, and options, one trades them over-the-counter.
There are different types of swap contracts. They include:
- Interest Rate Swaps
It involves exchanging cash flows at a fixed interest rate with those that have a floating interest rate. The parties do not swap the principal. The notional amount is the size of the swap and is what we use to calculate the cash flows. There are different kinds of interest swaps which include:
- Plain vanilla swap – It is the most straightforward kind where one party exchanges a fixed rate for a floating rate and vice versa on the pre-agreed intervals in the life of the contract.
- Basis swap – Where both legs have a floating charge, the parties could exchange the floating rates using benchmark rates as the basis.
- Amortizing swap – As the swap meaning suggests, one could provide for a reduction in the notional amount to correspond to the amortization of a loan.
- Step-up swap – Opposite of the amortizing swap, notional amount increases as per agreement.
- Differential swap – In these swaps, one leg of provides for payment of an interest rate for another currency other than that of the initial principal amount. The other leg caters for paying interest at the rate and currency of the initial principal.
- Currency Swap
This type of swap involves the counterparties exchanging the principal amount and interest payments in different currencies. They hedge another investment position from fluctuations in the currency exchange rate.
- Basis Swaps
In basis swaps, both legs have different floating rates. It could either be an interest rate swap or a currency swap where both streams of cash flow have a floating rate. Most swap contracts base payments on a fixed rate against a floating rate. In this case, we calculate both legs on floating rates.
- Commodity swap
For commodity swap contracts, the counterparties exchange floating cash flows based on a commodity’s spot price for fixed cash flows. They determine them based on a pre-agreed amount of a product.
- Credit default swap
Commonly known as CDS, it provides insurance from the default of a financial debt instrument. The purchaser transfers the premium payments to the seller. If by any chance the asset defaults, the seller is bound to reimburse the buyer face value of the asset in question.
Swaps are a crucial part of finance these days. The most common application of swap meaning is hedging against risk. For example, interest rate swaps to hedge against interest rate fluctuation and currency credit default swap against a default of a debt instrument.