# User Contributed Dictionary

### Noun

swaps- Plural of swap

### Verb

- Third person singular simple present of to swap.

# Extensive Definition

expert-subject Business
and Economics

- ''For the Thoroughbred horse racing champion, see: Swaps (horse).

In finance, a swap is a derivative
in which two counterparties agree to
exchange one stream of cash flows against another stream. These
streams are called the legs of the swap.

The cash flows are calculated over a notional
principal amount, which is usually not exchanged between
counterparties. Consequently, swaps can be used to create unfunded
exposures to an underlying asset, since counterparties can earn the
profit or loss from movements in price without having to post the
notional amount in cash or collateral.

Swaps can be used to hedge
certain risks such as interest
rate risk, or to speculate on changes in the
underlying prices.

## Structure

A swap is an agreement between two parties to exchange future cash flows according to a prearranged formula. They can be regarded as portfolios of forward contracts. The streams of cash flows are called “legs” of the swap. Usually at the time when contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as interest rate, foreign exchange rate, equity price or commodity price.Most swaps are traded
Over The Counter (OTC), "tailor-made" for the counterparties.
Some types of swaps are also exchanged on futures markets, for
instance Chicago Mercantile Exchange Holdings Inc., the largest
U.S. futures market, the Chicago Board Options Exchange and
Frankfurt-based Eurex AG. David Swensen, a Yale Ph.D. at Salomon
Brothers, engineered the first swap transaction according to "When
Genius Failed: The Rise and Fall of Long-Term Capital Management"
by Roger Lowenstein.

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.

The
Bank for International Settlements (BIS) publishes statistics
on the notional
amounts outstanding in the OTC Derivatives
market. At the end of 2006, this was USD 415.2 trillion, more
than 8.5 times the
2006 gross world product. However, since the cash flow
generated by a swap is equal to an interest rate times that
notional amount, the cash flow generated from swaps is a
substantial fraction of but much less than the gross world product
-- which is also a cash-flow measure. The majority of this (USD
292.0 trillion) was due to interest
rate swaps. These split by currency as:

- Source: "The Global OTC Derivatives Market at end-December 2004", BIS, http://www.bis.org/publ/otc_hy0505.htm, "OTC Derivatives Market Activity in the Second Half of 2006", BIS, http://www.bis.org/publ/otc_hy0705.pdf

### Example

Take the case of a plain vanilla fixed-to-floating interest rate swap. Here party A makes periodic interest payments to party B based on a variable interest rate of LIBOR +50 basis points.Party B in turn makes periodic interest payments
based on a fixed rate of 3%. 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 LIBOR.

## Total return swap

A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.Total return swap (also known as total rate of
return swap, or TRORS) is a contract
in which one party receives interest payments on a reference asset
plus any capital gains and losses over the payment period, while
the other receives a specified fixed or floating cash flow
unrelated to the credit worthiness of the reference asset,
especially where the payments are based on the same notional
amount. The reference asset may be any asset, index, or basket of
assets.

The TRORS, then, allows
one party to derive the economic benefit of owning an asset without
putting that asset on its balance sheet, and allows the other
(which does retain that asset on its balance sheet) to buy
protection against a potential decline in its value.

The essential difference between a TRORS and a
credit
default swap is that the latter provides protection not against
loss in asset value but against specific credit events. In a sense,
a TRORS isn’t a credit derivative at all, in the sense that a
credit default swap is. A TRORS is funding-cost
arbitrage.

## Equity Swap

An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have.## Valuation

The value of a swap is the net present value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future cash flows is equal to zero.For example, consider a plain vanilla
fixed-to-floating interest rate swap where Party A pays a fixed
rate, and Party B pays a floating rate. In such an agreement the
fixed rate would be such that the present value of future fixed
rate payments by Party A are equal to the present value of the
expected future floating rate payments (i.e. the NPV is zero).
Where this is not the case, an Arbitrageur, C,
could:

- assume the position with the lower present value of payments, and borrow funds equal to this present value
- meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
- use the received payments to repay the debt on the borrowed funds
- pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

## Variations

Variations of swaps include cross currency swaps, amortizing swaps and so on.### Interest Rate Swaps

The most common type of swaps is a “plain
Vanilla” interest rate swap. It is the exchange of a fixed rate
loan to a floating rate loan. The life of the swap can range from 2
years to over 15 years. The reason for this exchange is to take
benefit from comparative advantage. Some companies may have
comparative advantage in fixed rate markets while other companies
have a comparative advantage in floating rate markets. When
companies wanted to borrow they look for cheap borrowing i.e. from
the market where they have comparative advantage. However this may
lead to a company borrowing fixed when it wants floating or
borrowing floating when it wants fixed. This is where a swap comes
in. A swap has the effect of transforming a fixed rate loan into a
floating rate loan or vice versa.

### London Inter Bank Offer Rate (LIBOR)

LIBOR is the rate of interest offered by banks on
deposit from other banks in euro currency market. One month LIBOR
is the rate offered for 1-month deposits, 3-month LIBOR for three
months deposits, etc. LIBOR rates are determined by trading between
banks and change continuously as economic conditions change. Just
prime rate of interest quoted in the domestic market, LIBOR is a
reference rate of interest in the International Market.

### Currency Swaps

The Currency Swap involves exchanging principal
and fixed rate interest payments on a loan in one currency for
principal and fixed rate interest payments on an equal loan in
another currency. Just like interest rate swaps, the currency swaps
also are motivated by comparative advantage.

## Options

An option on a swap is called a swaption.## References

- Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006

## See also

## External links

- swaps index, quantnotes.com
- swaps-rates.com, Interest swap rates statistics online
- Bank for International Settlements

swaps in German: Swap (Wirtschaft)

swaps in Spanish: Swap (finanzas)

swaps in French: Swap (finance)

swaps in Italian: Swap (finanza)

swaps in Dutch: Swap (financieel)

swaps in Polish: Swap

swaps in Portuguese: Swap

swaps in Russian: Своп (финансы)

swaps in Swedish: Swap

swaps in Chinese: 掉期交易