What Is A Swap ?
A swap is an agreement between
two or more counterparties to exchange sets of cash flows over a
period in the future. A swap has an opening leg (the initial
exchange, also called the near-leg), a set of cashflows (not
always), and finally a closing leg (the final exchange, also called
Common characteristics of
There is an underlying notional principle (specified as
an amount of a commodity in a commodity swap, specified as a stock
portfolio in an equity swap)
There is a fixed tenor
One party pays fixed whilst the other pays floating or
both parties pay floating.
What Instruments Make Up The Swaps Market ?
The main type of swap is the
Interest Rate Swap (IRS). Equity swaps and commodity swaps also
exist. The main type of IRS is a currency swap and it is discussed
Interest rate swaps are the most heavily traded swap
The swaps market is entirely OTC. There are swap
brokers and swap broker dealers and specialist clearing houses such
as the London Clearing House that clear inter-bank interest-rate
swap trades. Most traders do not clear their swaps through a
clearing house but hedge the risk on their own books.
Swaps are generally cash
settled although physical delivery occurs for some commodity swaps.
In a short-term swap (or money market swaps) the
closing leg can be up to two years ahead.
In a long/medium-term swap the closing leg can
be from two years onwards (I've seen a 30-year swap
Interest Rate Swap
An interest rate swap
(IRS) is the exchange of two payment streams between two
counterparties over an agreed period. The payments are calculated
using different interest rates and are based on the same notional
principle amount. The
purpose of an IRS is to allow counterparties to convert an exposure
from one stream of payments into a second stream of payments. Normally, an IRS is the exchange of a fixed payment for a
floating payment with no principle being exchanged.
In essence an interest rate swap can be analysed
as a portfolio of forward contracts with successive expiration
dates. It can similarly, be considered as a strip of interest rate
Joxo agrees to pay
Barclays 6% a year for five years on $10 million in return for Barclays paying
Joxo a 6-month LIBOR on the same sum. The notional amount ($10 million) is not
actually transferred. Cash flows are normally netted so that only the
difference is paid by one of the counterparties.
IRS are used to get better
borrowing rates. If one company wants to borrow fixed-rate funds and another
company wants to borrow floating-rate funds it makes sense for them to swap.
The former can raise funds by issuing a floating rate note whilst the latter
can raise funds by issuing a fixed rate bond.
Swap prices are quoted in two
outright rate e.g. 6.5-7.0% (bank will receive fixed at 7% versus
LIBOR or pay fixed at 6.5% versus LIBOR)
A spread over a reference rate such as the
treasury yield for
the period of the swap
Many different types of IRS products exist.
There are swap futures and forwards where the opening leg is set to
some future date. Swap futures are traded on LIFFE. Swap options are
fairly popular and are called swaptions.
A coupon swap is an
interest rate swap in which one stream of
payments is based on a fixed interest rate and the other stream on
payments is based on a floating interest rate.
A basis swap is an
interest rate swap in which both streams
of payments are based on floating interest rates but each is
calculated on a different
asset swap is where one of the one payment streams is being funded
by an underlying asset (e.g. a bond), although the asset is never
exchanged. They are commonly used to create fixed-rate cash flows
from a floating-rate position or
An overnight index swap is a fixed/floating rate
short-term swap where the floating rate is referenced to the daily
An EONIA swap is a fixed/floating rate swap
where the floating rate is referenced to the EONIA.
A forward outright swap
(aka IRS outright) is when
the near-leg is completed at the spot rate whilst the far-leg is
completed at the forward rate.
An extendable swap is when counterparties agree
to extend the term of a swap.
Other types of interest rate swap:
Roller coaster swap
Yield Curve swap
Credit derivative swaps (CDS, TRS
swap is the exchange of a fixed amount of one currency per annum for
a fixed amount of another currency per annum followed by an exchange
of principal on maturity of the swap. It is commonplace, but not
essential, to exchange currency on the opening leg of the swap. All
currency flows are paid at an exchange rate agreed in
cross-currency swap (as opposed to just a currency swap) involves
the exchange of cashflows in different currencies with at least one
of the cashflows being based on a floating rate of interest.
Therefore, a cross-currency swap is either a cross-coupon swap or a
cross-currency basis swap.
Currency swaps are used to hedge foreign currency
exposures. The most
heavily traded currency swaps are: US dollars, Euro, Yen and
Other types of currency swap:
Seasonal currency swap
An equity swap is the exchange of two payment
streams between two counterparties over an agreed period where the
first party makes payments that are based on the returns on a stock
or a stock index and the counterparty makes payments of either a
fixed amount, a floating amount or payments based on the returns of
a stock or a stock index.
The returns from an
equity swap can be negative.
A commodity swap is the exchange of two payment
streams between two counterparties
where the cashflows are dependant on an
underlying commodity. The first party (e.g. an oil user) would pay a
fixed amount and receive payments based on the market value of the
commodity involved (i.e. a specified volume of the commodity over a
specified period). Note that an oil producer would do the opposite
i.e. make payments based on the market value of the commodity and
receive fixed payments for the commodity.
Commodity swaps are used to lock-in
the price of a commodity.
(option on a swap) provides the right but not the obligation to
enter into a price swap at a particular point in the future and at a
set price. The buyer can be the fixed-rate receiver (call swaption)
or the fixed-rate payer (put swaption). The agreed strike rate
represents the fixed rate that will be swapped against the floating
Lifecycle For Vanilla Swaps
Date (aka fixing date). The terms of the swap are agreed i.e.
maturity, swap rate, floating interest rate index, payment frequency, notional
Start Date. Date on which the first floating rate is set. For spot
swaps this is the trade date. For forward start swaps it is after the trade
3.Value Date. The
interest payments start to accrue. This is either the trade date (for domestic
currency) or T+2 for foreign currency.
The floating rate index is adjusted to the current market rate for
the next interest period.
Interest is paid for the preceding period. Effective
dates are normally calculated from value dates and are normally the same day as
the refixing date (for domestic currency) or two business days later (for
The last interest payments are made. Maturity is agreed at the start or
calculated using the value date.
The tenor is the period in years from value
date until maturity date.
The front stub period is the time from
value date until the first payment.
"Reach for the unreachable and always believe"