A swap is nothing but a barter or exchange but it plays a very important role in international finance. A swap is the exchange of one set of cash flows for another. A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first. Both payments take place on specified dates. Different formulas are used to determine what the two sets of payments will be.

Classification of swaps is done on the basis of what the payments are based on. The different types of swaps are as follows.

• Interest rate swaps
• Currency Swaps
• Commodity swaps
• Equity swaps

Interest rate swaps

The interest rate swap is the most frequently used swap. An interest rate swap generally involves one set of payments determined by the Eurodollar (LIBOR) rate. Although, it can be pegged to other rates. The other set is fixed at an agreed-upon rate. This other agreed upon rate usually corresponds to the yield on a Treasury Note with a comparable maturity. Although, this can also be variable.

Additionally, there will be a spread of a pre-determined amount of basis points. This is just one type of interest rate swap. Sometimes payments tied to floating rates are used for interest rate swaps. The notional principal is the exchange of interest payments based on face value. The notional principal itself is not exchanged. On the day of each payment, the party who owes more to the other makes a net payment. Only one party makes a payment.

Currency swaps

A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency. Currency swaps are similar yet notably different from interest rate swaps and are often combined with interest rate swaps.

Currency swaps help eliminate the differences between international capital markets. Interest rates swaps help eliminate barriers caused by regulatory structures. While currency swaps result in exchange of one currency with another, interest rate swaps help exchange a fixed rate of interest with a variable rate. The needs of the parties in a swap transaction are diametrically different. Swaps are not traded or listed on exchange but they do have an informal market and are traded among dealers.

A swap is a contract, which can be effectively combined with other type of derivative instruments. An option on a swap gives the party the right, but not the obligation to enter into a swap at a later date.

Commodity swaps

In commodity swaps, the cash flows to be exchanged are linked to commodity prices. Commodities are physical assets such as metals, energy stores and food including cattle. E.g. in a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.

Commodity swaps are used for hedging against

• Fluctuations in commodity prices or
• Fluctuations in spreads between final product and raw material prices (E.g. Cracking spread which indicates the spread between crude prices and refined product prices significantly affect the margins of oil refineries)

A Company that uses commodities as input may find its profits becoming very volatile if the commodity prices become volatile. This is particularly so when the output prices may not change as frequently as the commodity prices change. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and pays a fixed rate in exchange. A producer of a commodity may want to reduce the variability of his revenues by being a receiver of a fixed rate in exchange for a rate linked to the commodity prices.

Equity swaps

Under an equity swap, the shareholder effectively sells his holdings to a bank, promising to buy it back at market price at a future date. However, he retains a voting right on the shares.

What are the components of a swap price?

There are four major components of a swap price.

• Benchmark price
• Liquidity (availability of counter parties to offset the swap).
• Transaction cost
• Credit risk

Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.

Liquidity: Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counterparties for long duration swaps, especially so in India.

Transaction Costs: Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference.

Yield on 91 day T. Bill — 9.5%

Cost of fund (e.g.- Repo rate) – 10%

The transaction cost in this case would involve 0.5%

Credit Risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.