A Swap is an agreement to exchange a sequence of cash flows over a period of time in the future in same or different currencies. Mainly used for hedging various interest rate exposures, they are very popular and highly liquid instruments. Some of the very popular swap types are
Fixed – Float (Same currency) Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a tenor T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 mio for 3 years. Fixed-Float swaps in same currency are used to convert a fixed/floating rate asset/liability to a floating/fixed rate asset/liability. For example, if a company has a fixed rate USD 10 mio loan at 5.3% paid monthly and a floating rate investment of USD 10 mio that returns USD 1M Libor +25 bps monthly, and wants to lockin the profit as they expect the USD 1M Libor to go down, then they may enter into a Fixed-Floating swap where the company pays floating USD 1M Libor+25 bps and receives 5.5% fixed rate, locking in 20bps profit.
Fixed – Float (Different currency) Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay fixed 5.32% on the USD notional 10 mio quarterly to receive JPY 3M Tibor monthly on a JPY notional 1.2 bio (at an initial exchange rate of USDJPY 120) for 3 years. For Nondeleverable swaps, USD equivalent of JPY interest will be paid/received (as per the Fx rate on the FX fixing date for the interest payment day). Note in this case no initial Exchange of notional takes place unless the Fx fixing date and the swap start date fall in the future. Fixed-Float swaps in different currency are used to convert a fixed/floating rate asset/liability in one currency to a floating/fixed rate asset/liability in a different currency. For example, if a company has a fixed rate USD 10 mio loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 bio that returns JPY 1M Libor +50 bps monthly, and wants to lockin the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up(JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the fx exposure.
Float – Float (Same Currency, different index) Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N for a tenor T years. For example, you pay JPY 1M Libor monthly to receive JPY 1M Tibor monthly on a notional JPY 1 bio for 3 years.
In this case, company wants to lockin the cost from the spread widening or narrowing. For example, if a company has a floating rate loan at JPY 1M Libor and the company has an investment that returns JPY 1M Tibor+30 bps and currently the JPY 1M Tibor = JPY 1M Libor +10bps. At the moment, this company has a net profir of 40 bps. If the company thinks JPY 1M tibor is going to come down or JPY 1M Libor is going to increase in the future and wants to insulate from this risk, they can enter into a Float float swap in same currency where they pay JPY TIBOR +10 bps and receive JPY LIBOR+35 bps. with this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5bps difference comes from the swap cost which includes the market expectations of the future rates in these two indices and the bid/offer spread which is the swap commission for the swap dealer.
Float – Float (Different Currency) Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A indexed to Y on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay floating USD 1M libor on the USD notional 10 mio quarterly to receive JPY 3M Tibor monthly on a JPY notional 1.2 bio (at an initial exchange rate of USDJPY 120) for 4 years.
To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 bio. the easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market with out a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate Debt issuance program in Japan and they might lack sophesticated treasury operation in Japan. To overcone the above problems, they can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company. 1. Fx risk. If this if this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss 2. USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in Japan might go down and this introduces a interest rate risk component.
First exposure in the above can be hedged using long dated FX forward contracts but this introduces a new risk where the implied rate from the Fx Spot and the Fx Frward is a fixed rate but the JPY invest ment returns a floating rate. Although there are several alternatives to hedge both the exposures effectively with out introducing new risks, the easiest and the most cost effective alternative would be to use a Float-Float swap in different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate(so matching the interest payments on the USD Debt) and pays JPY floating rate matching the returns on the JPY investment.
Fixed – Fixed (Different Currency) Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a tenor T years. For example, you pay JPY 1.6% on a JPy notional of 1.2 bio and receive USD 5.36% on the USD equivalent notional of 10 mio at an initial exchange rate of USDJPY 120.
Usage is similar to above but you receive USD fixed rate and pay JPY Fixed rate.
Primarily used as hedging instruments, against varying interest payments. The base concept is quite easy to follow; you swap a fixed rate for a floating rate or vice-versa. In the case of companies that offer Variable Rate Bonds, they can enter into a swap agreement with a broker/dealer; where the company pays the broker a fixed rate as per agreement and the broker provides them with the floating rate, which can be used to make periodic coupon payments. In essence, the company has hedged it’s risk against a sudden rate increase, as it is locked in a fixed rate over time. Swaps may be terminated with one party paying it’s counterpart a certain fee, which may have been determined at time of initial agreement or may be based on future payments if interest rates were to remain constant.