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MEANING OF SWAP

Swap is a derivative in which counter parties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds , the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. pecifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated. !sually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate equity price or commodity price. The cash flows are calculated over a notional principal amount ,which is usually not exchanged between counterparties. "onsequently, swaps can be in cash or collateral. waps can be used to hedge certain ris#s such as interest rate ris# , or to speculate on changes in the expected direction of underlying prices. waps were first introduced to the public in $%&$ when '() and the *orld (an# entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world+ the total amount of interest rates and currency swaps outstanding is more th,n -./0.1 trillion in /22%, according to 'nternational waps and 3erivatives 4ssociation (' 34).

TYPES OF SWAPS
The five generic types of swaps, in order of their quantitative importance, are+ interest rate swaps ,currency swaps, credit swaps, commodity swaps and equity swaps . There are also many other types.

1. Interest rate swaps:The most common type of swap is a 5plain 6anilla7 interest rate swap. 't is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from / years to over $8 years. The reason for this exchange is to ta#e benefit from comparative advantage . ome companies may have comparative advantage in fixed rate mar#ets while other companies have a comparative advantage in floating rate mar#ets. *hen companies want to borrow they loo# for cheap borrowing i.e. from the mar#et where they have comparative advantage. 9owever this may

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lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. 4 swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa. For example, party ( ma#es periodic interest payments to party 4 based on a variable interest rate of :'(;< =12 basic points . >arty 4 in return ma#es periodic interest payments based on a fixed rate of &.08?. The payments are calculated over the notional amount. The first rate is called variable, because it is reset at the beginning of each interest calculation period to the then current reference rate , such as :'(;< . 'n reality, the actual rate received by 4 and ( is slightly lower due to a ban# ta#ing a spread.

4 is currently paying floating, but wants to pay fixed. ( is currently paying fixed but wants to pay floating. (y entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. @ormally the parties do not swap payments directly, but rather, each sets up a separate swap with a financial intermediary such as a ban#. 'n return for matching the two parties together, the ban# ta#es a spread from the swap payments.

Uses
'nterest rate swaps were originally created to allow multiAnational companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates. Speculation 'nterest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today,

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investors with a similar view could enter a floatingAforAfixed interest rate swapB as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate. 'nterest rate swaps are also very popular due to the arbitrage opportunities they provide. 3ue to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap. The interest rate swap mar#et is closely lin#ed to the Curodollar futures mar#et which trades at the "hicago )ercantile Cxchange.(ritish local authorities

2. Currency swaps:4 commodity swap is an agreement whereby a floating (or mar#et or spot) price is exchanged for a fixed price over a specified period. The vast maDority of commodity swaps involve crude oil. 4 currency swap is a foreignAexchange agreement between two parties to exchange aspects (namely the principal andEor interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currencyB see foreign exchange derivative. "urrency swaps are motivated by comparative advantage. 4 currency swap should be distinguished from a central ban# liquidity swap

Structure
"urrency swaps are overAtheAcounter derivatives, and are closely related to interest rate swaps. 9owever, unli#e interest rate swaps, currency swaps can involve the exchange of the principal.F$G There are three different ways in which currency swaps can exchange loans+
1.

2.

The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. uch an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, ma#es swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. 9owever for the longer term future, commonly up to $2 years, where spreads are wider for alternative derivatives, principalAonly currency swaps are often used as a costAeffective way to fix forward rates. This type of currency swap is also #nown as an FHAswap.F/G 4nother currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. 'n such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. 4s each party effectively borrows on the other's behalf, this type of swap is also #nown as a bac#AtoAbac# loan.F/G

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I. :ast here, but certainly not least important, is to swap only interest payment cash flows on loans of the same siJe and term. 4gain, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. 4n example of such a swap is the exchange of fixedArate ! dollar interest payments for floatingArate interest payments in Curo. This type of swap is also #nown as a crossAcurrency interest rate swap, or crossA currency swap.

Uses
"urrency swaps have two main uses+

To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a bac#AtoAbac#Aloan). To hedge against (reduce exposure to) exchange rate fluctuations.

Hedging example For instance, a ! Abased company needing to borrow wiss francs, and a wissAbased company needing to borrow a similar present value in ! dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following+

'f the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. 4lternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principalAonly swap.

3. Equity Swap:4n equity swap is a special type of total return swap, where the underlying asset is a stoc#, a bas#et of stoc#s, or a stoc# index. "ompared to actually owning the stoc#, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stoc# holders do. 4n equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as KlegsK of the swapB one of these KlegsK is usually pegged to a floating rate such as :'(;<. This leg is also commonly referred to as the Kfloating legK. The other leg of the swap is based on the performance of either a share of stoc# or a stoc# mar#et index. This leg is commonly referred to as the Kequity legK. )ost equity swaps involve a floating leg vs. an equity leg, although some exist with two equity legs 4n equity swap involves a notional

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principal, a specified tenor and predetermined payment intervals. Cquity swaps are typically traded by 3elta ;ne trading des#s. Cquity swaps also provide the following benefits over plain vanilla equity investing+ $. 4n investor in a physical holding of shares loses possession on the shares once he sells his position. 9owever, using an equity swap the investor can pass on the negative returns on equity position without losing the possession of the shares and hence voting rights. For example, let's say 4 holds $22 shares of a >etroleum "ompany. 4s the price of crude falls the investor believes the stoc# would start giving him negative returns in the short run. 9owever, his holding gives him a strategic voting right in the board which he does not want to lose. 9ence, he enters into an equity swap deal wherein he agrees to pay >arty ( the return on his shares against :'(;<=/8bps on a notional amt. 'f 4 is proven right, he will get money from ( on account of the negative return on the stoc# as well as :'(;<=/8bps on the notional. 9ence, he mitigates the negative returns on the stoc# without losing on voting rights. /. 't allows an investor to receive the return on a security which is listed in such a mar#et where he cannot invest due to legal issues. For example, let's say 4 wants to invest in company H listed in "ountry ". 9owever, 4 is not allowed to invest in "ountry " due to capital control regulations. 9e can however, enter into a contract with (, who is a resident of ", and as# him to buy the shares of company H and provide him with the return on share H and he agrees to pay him a fixed E floating rate of return. Cquity swaps, if effectively used, can ma#e investment barriers vanish and help an investor create leverage similar to those seen in derivative products.

4. Credit default swaps:4 credit default swap ("3 ) is a swap contract in which the buyer of the "3 ma#es a series of payments to the seller and, in exchange, receives a payoff if a instrument A typically a bond or loan A goes into default (fails to pay). :ess commonly, the credit event that triggers the payoff can be a company undergoing restruct uring , ban#ruptcy or even Dust having its credit rating downgraded. "3 contracts have been compared with insurance , because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. !nli#e an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure. 4 credit default swap (CDS) is similar to a traditional insurance policy, in as much as it obliges the seller of the "3 to compensate the buyer in the event of loan default. Lenerally, the agreement is that in the event of default the buyer of the "3 receives money (usually the face value of the loan), and the seller of the "3 receives the defaulted loan (and with it the right to recover the loan at some later time).

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9owever, there is a significant difference between a traditional insurance policy and a "3 . 4nyone can purchase a "3 , even buyers who do not hold the loan instrument and may have no direct insurable interest in the loan. The buyer of the "3 ma#es a series of payments (the "3 KfeeK or KspreadK) to the seller and, in exchange, receives a payoff if the loan defaults.These are called Kna#edK "3 , and in fact are a KbetK on default. The Curopean >arliament has approved a ban on this #ind of "3 , effective starting $st 3ecember /2$$.

Other variations:There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.

4 total return swap is a swap in which party 4 pays the total return of an asset, and party ( ma#es periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. @ote that if the total return is negative, then party 4 receives this amount from party (. The parties have exposure to the return of the underlying stoc# or index, without having to hold the underlying assets. The profit or loss of party ( is the same for him as actually owning the underlying asset. 4n option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap. 4 variance swap is an overAtheAcounter instrument that allows one to speculate on or hedge ris#s associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap. 4n Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmar# such as the :'(;<. 't is suitable to those customers of ban#s who want to manage the interest rate ris# involved in predicted funding requirement, or investment programs. 4 Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would li#e to conserve cash for operational purposes. 4 Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future. 4n Accreting swap is used by ban#s which have agreed to lend increasing sums over time to its customers so that they may fund proDects.

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4 Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific timeAframe needs of an investor. 4lso referred to as a forward start swap, delayed start swap, and a deferred start swap.