Swaps as a derivative instrument
A contract between two parties which specifies the conditions and includes the dates, maturity value, underlying variables and the notional amounts is known as Derivatives. There are two classes of this derivative instrument, namely:
• Contingent claims (options)
• Forward Claims (ETF’s Swaps, forward contracts)
In this article we would discuss what are SWAPS, its types, and other implications. As per definition SWAP is defined as an agreement in between 2 parties where they agree to exchange a sequence of cash flows for a defined period of time. Generally when the contract gets initiated one of the series from cash flows under the agreement gets determined with a random or an uncertain variable. It may include the interest rate, equity prices, foreign exchange rate, and the commodity prices. Moreover if we look at SWAPS we may say it is a portfolio of several forward contracts or a long position of a bond in addition to a short position in an another bond. There are two types of SWAPS which we would come across when the discussion of the SWAPS as an instrument is discussed. They are:
• Plain Vanilla Interest Rate
• Plain Vanilla Foreign Currency Swap
One of the key differences between the SWAPS and the standardized options or the futures contracts is that these are not an exchange traded funds. Moreover these are customized contracts which are traded through the OTC (Over the Counter) between two private parties. Basically the SWAP markets are dominated by the firms or the financial institutions with much lessor individuals playing in the domain. The risk of the counterpart to default is always lingering in terms of a SWAP contract as it is an OTC derivative.
The first interest rate swap dates back to the early 80s which had occurred between the World Bank and IBM. Although they are one of the newest derivatives they gained popularity in the next decade after its release. It was so popular that by the year 2006 the traded figure crossed S250 trillion which was 15 times the US equity markets.
Who would be interested in SWAP contract?
Basically it is believed that there are two things which motivate the parties to be interested to enter into a SWAP agreement. They are:
• Commercial Needs
• Comparative advantage
In a normal functioning of a business it leads to various kinds of interest rate as well as currency exposures which can be alleviated by the use of SWAPS. Considering an example wherein a bank pays the floating interest rate on deposits and gets a fixed interest rate on the loans. Here the payout is a liability and the interest on loans earned is the asset for the bank. The possibility of mismatch in the assets and liabilities is quite high which could be countered by using a fixed pay swap and convert the fixed rate assets into the floating rate assets. This in turn would help in matching up the floating rate of liabilities easily.
There are several companies who take a comparative advantage for acquisition and various types of financing methods. Therefore a company can acquire finances for which it gets comparative advantage and use a swap for converting it to a desired kind of financing.
Concluding Remarks:
Overall SWAPS are regarded as one of the most confusing topics; however it is regarded as one of best financing options available. It actually provides the organizations with a very different method of receiving finances which actually would have been impossible for them to receive under any of the other finances available. This as a financial tool needs to be studied a lot and the concept needs to be made much simpler so that people are educated on how to use the SWAPS as financing option. The thing that should be noted is that these provide the organizations with great comparative advantage as compared to the other options available.
ADVERTISEMENTS
Pankaj Priyadarshi
Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).
Related posts:
Loading ...