Swap is a derivative contract through which two parties exchange financial instruments.  Swap instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to.

Interest Rate swaps:

Considering an Example: A borrows 1,00,000 from party B for 3 years at floating rate(MIBOR) and part b borrows 1,00,000 from party A for 3 years at a fixed rate of 5%. Each party is going to give a series of cash flows to another party and essentially there is a swap of cash flows taking place. Payments are shown on the timeline. A pays floating rate and B pays fixed rate.

  1. Notional                                 A pays 4%
    Principal                                 B pays 5%
    NET : B pays 1%
    (B pays 1000)         (MIBOR=4%)
  2. Notional                               A pays 5%
    Principal                               B pays 5%
    NET : 0
    (Becomes equal)  (MIBOR=5%)
  1. Notional                            A pays 6%
    Principal                             B pays 5%
    NET: A will pay 1%
    (A pays 1000)  (MIBOR=6%)

(Notional principal: Principal on which we are calculating interest. Since the amount is swapped that is it 1, 00,000 in both the cases there is no need to exchange anything this is known as notional principal).

If the same is put in formula terms
Net fixed rate = (Swap fixed Rate – MIBORt-1) no of days* notional principal

For the period 3, it comes to -1000, which simply means that the fixed rate payer is receiving 1000 and the floating rate payer needs to make the payment.
From the above all its seen that B will benefit if the interest rate goes up since he is entitled to pay only a fixed rate.

Characteristics of swap contracts  

pc: financetrain.com
Swap pc: financetrain.com
  1. They are not traded in an organized secondary market. They are custom instruments like a forward contract.
  2. To get into a swap contract, approach an entity called swap facilitator who might either find a counterparty to the trade or might take the opposite position from the trader. Suppose you’re a large entity and you have taken up loans at floating rate you can now swap them to fixed rates through an authorized derivative dealer.
  3. It is an unregulated market.
  4. Default risk or the credit risk is the matter of concern since there is no exchange or clearing house regulating the trade.
  5. Generally, large institutions only participate in such swap contracts.
  6. It is a private agreement
  7. Once a swap contract is made it’s generally difficult to terminate or alter the contract.

Swap is like a series of FRA (Forward Rate Agreements)

  • Suppose a trader in swap contact is paying a fixed amount every period say 5%. When this 5% is compared with MIBOR the fixed rate payer will gain when the floating rate(MIBOR) goes up , suppose it goes up to 7% , the fixed rate payer will just pay 5%, gain if 2%. This single swap contract is essentially equivalent to two forward rate agreements. That is the forward rate agreements which start at the end of year 1 and goes till the end of period 2, at the rate of 5% along with, which includes another FRA which starts at the end of period 2 and goes till year3 which the same rate of 5%. So the combination of this series of FRA guarantees the payment of 5% each year just like the swaps.
  • There is no need for payment in the initial just like FRA’s.

There are mainly two types of swaps:

  1. Currency swaps: Actual currencies are exchanged forinitiation, the cash flows are being exchanged at different currencies.
  2. Equity swaps:
  • Party A pays a return on index B pays a fixed rate
  • Party A pays return on index  B pays a floating rate
  • Party A pays return on index  B pays return on another index

Thus Swap is a contract where mainly two instruments are exchanged.