SWAPS

 

What is Swaps?
  A SWAP in the financial world refers to a derivative contract where one party will exchange the value of an asset or cash flows with another. “Exchange of Cash flows based on the Underlying”. In finance, a SWAP is an agreement between two counterparties to exchange financial instruments cash flow, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principle amount. The general swap can also be seen as a series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap. The legs can be almost anything but usually one leg involves cash flows based on a notional principle amount that both parties agree to. This principal usually does not change hands during or at the end of the swap; this is contrary to future, a forward or an option. 

In practice one leg is generally fixed while the other is variable, that is determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price. 

Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps.

In this topic we will discuss about 4 types of SWAPS

FX SWAPS

Equity SWAPS 

Interest Rate SWAPS (IRS)

Credit Default SWAPS (CDS)

FX SWAPS:

It is a combination of two FX Trades with the same Trade date & different settlement date. It is mainly used for speculation. 

Different types of FX Deals:

Cash Deal- Trade Date=Settlement (TD=07/05/2021 & SD=07/05/2021)

TOM Deal-Trade Date= 1 day (TD=07/05/2021 & SD=08/05/2021)

Spot Deal- Trade Date= 2 days (TD=07/05/2021 & SD=09/05/2021)

Forward Deal-Trade Date=2> greater than 2 days (TD=07/05/2021 & SD= 20/05/2021)

EQUITY SWAPS:

“Equity Swaps is an OTC Derivatives contract that exchanges cash flows based on the performance of an Equity or an Index”. One Leg of the swaps contract has to be an equity or an Index.

Example: Equity Vs Equity, Equity Vs Index, Index Vs Index or Equity Vs Floating Rates.

CREDIT DEFAULT SWAP:

It is an agreement to buy Protection against a credit Even on a Fixed Income Underlyer. Credit default swap came into existence in 1994 when they were invented by the Masters from the JP Morgan. Underlying asset of a CDS Like Bonds, ABS and MBS. Credit Default Swap is like a Insurance Policy.

How is Premium decided on CDS Contract?

Survival Rate

Recovery Rate

Premium

30% (Low)

70% (High)

High 

70% (High)

30% (Low)

Low

Survival Rate: The probability that the company might default in the market

Recovery Rate: The amount you will recover in case the company defaults

Premiums: The amount you pay to enter into CDS Contract.

 

INTEREST RATE SWAPS: 

An IRS is an agreement between two parties to Exchange one stream of interest payment for another over a set period of time. SWAPS are derivatives contract & Trade on OTC Market.

Types of Interest Rate:

Fixed Rate: The Interest rate is fixed throughout the life of the loan.

Floating Rate: The Interest rate keeps varying through out the life of the loan.

Floating is also known as “BENCHMARK RATE”

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