Derivatives: Swaps Contracts

This is the second article on my two-part series on derivative contracts.

Swaps Contract

A contract where two parties exchange cash flows OTC (over the counter) over a period. The main purpose is to hedge interest rate risk.

Interest rate swap

These are used by a party to hedge interest rates on a bank loan.

Two parties exchange different interest rates on a notional principal amount (fixed amount of cash typically the same as the bank loan.)

They only exchange the difference (whichever party owes money to the other.)

The payments occur at agreed intervals.

Example:

Party A has a loan from a bank they’re paying a floating interest rate e.g. SOFR + 2%.

They want to lock in a fixed rate to protect themselves from potential rising interest rates.

Notional Principal: $1M – often same as bank loan value.

Party A pays a fixed interest rate e.g. 3% to Company B.

Company B pays a floating rate e.g. SOFR + 2% to Company A (same rate Company A pay the bank).

One party will pay the other the difference of what they owe.

Company A are now protected if interest rates rise as Company B will pay them the excess which they can use to pay the bank.

Currency swap

These allow parties to access foreign capital at much cheaper rates.

1.     2 parties agree to exchange principal and interest payments in different currencies over a set period.

2.     Each party borrows money (principal amount) in their local currency with local rates

3.     They exchange principal amounts.

4.     They each pay the other interest (fixed rate determined when deal was arranged) on the currency they have.

5.     They swap back exchange principal to original value.

Example:

• Party A (UK company) needs $10 million US 

• Party B (US company) needs £8 million GBP.

• Party A borrows £8 million GBP from a UK bank.

• Party B borrows $10 million USD from a US bank.

  
  

• Party A gives its £8 million GBP to Party B.

• Party B gives its $10 million USD to Party A.

Both parties have their required currencies (but pay local interest rates which are typically cheaper.)

Party A pays interest to Party B on the $10 million USD it received (USD interest rate).

Party B pays interest to Party A on the £8 million GBP it received (GBP interest rate).

They swap back the principal amounts at the same exchange rate they agreed at the start (so no currency risk on principal.)

Party A gives back $10 million USD to Party B.

Party B gives back £8 million GBP to Party A.

Total return swap (TRS)

One party receives the returns of an asset without owning it by paying a fixed rate to the other party which owns the asset.

  Key terms:

Total return payer – owns an asset and transfers returns without selling it.

Total return receiver – receives returns of asset without owning it.

Example:

• Firm A owns an asset.

• Firm B wants exposure to the asset without buying it.

• Firm A pays (gives) B the returns of the asset.

• Firm B pays A a fixed or floating interest rate for the asset returns.

• If the asset increases in value firm B benefits.

• If it drops B only carries the loss through the swap interest rate and not actual ownership of the asset.

Commodity swap

This is used to exchange a fixed commodity price for a floating market-based price.

Example:

Hedging a commodity price-risk.

• An airline fears jet fuel prices will rise.

• A trader thinks fuel prices will drop.

Then

• The airline agrees to pay $90/barrel fixed.

• The trader agrees to pay floating market price.

Then

• If the market price rises to $100.

• The trader pays the airline the difference.

• If the market falls to $80.

• The airline pays the trader.

Credit Default Swap

These act as insurance in case a borrower defaults on payments.

CDS Buyer – pays a regular fee (premium) to CDS seller on the asset e.g.3%

CDS Seller – agrees to compensate the buyer if borrower defaults

• They are used to hedge the risk of owning loans or bonds from risky borrowers

• CDS price represents the assumed risk i.e. a higher premium means riskier borrower

Example:

You own £1M worth of Nike bonds

You fear they might default on payment so buy a CDS with a premium of 2%

If Nike defaults - you lose your 3% (like regular insurance)

If Nike don't default - the CDS seller pays you face value of the bond

CDS spread (e.g. 200 bps = 2%) shows how risky the market thinks the borrower is

50 bps – low default risk

300 bps – moderate default risk

1000+ bps – very high default risk

CDS were instrumental to the 2008 financial crisis! I would highly recommend The Big Short which explains it all surprisingly well in rather entertaining fashion.

This can be a lot to wrap your head around but I hope this was a good explanation. Check out my other stuff here!