Swaps "is a contract whereby both parties agree to exchange cash flows on a certain principal at regular intervals of time during a given period." (Monroy, 2001).
Swaps are used to reduce or mitigate interest rate risks, exchange rate risk and in some cases are used to reduce credit risk.
These instruments are OTC (Over The Counter or Above the Counter), that is, made to order. But, they always incur a certain level of credit risk caused by their operation.
Interest rate swaps
This type of contract is the most common in the financial markets.
“A normal interest rate swap is a contract by which one party to the transaction agrees to pay the other party an interest rate set in advance on a nominal amount also set in advance, and the second party agrees to pay the first at a variable interest rate on the same face value ”. (Rodríguez, 1997).
A swap is not a loan, since it is exclusively an exchange of interest rate flows and no one lends the nominal amount to anyone, that is, the amounts of principal are not exchanged.
Exchange rate swaps
In this type of contract (or financial swap) “a party agrees to pay interest on a certain amount of principal in a currency. On the other hand, it receives interest on a certain amount of principal in another currency ”. (Hull, 1996).
This is a variant of the interest rate swap, "in which the nominal on which the fixed interest rate is paid and the nominal on which the variable interest rate is paid are in two different currencies." (Rodríguez, 1997).
Unlike the previous swap (interest rate swap) in this one, the amounts of principal are exchanged at the beginning and end of the life of the swap.
This in turn can be used to transform a loan in one currency into a loan in another currency.
Since it can be stated that a swap is a long position in one obligation combined with a short position in another obligation.
A swap can be considered as a portfolio of forward contracts.
For example, financial institutions today often receive a swap as a deposit.
To expand on the idea of how a swap works, here is an example of a currency swap made between IBM and the World Bank in 1981:
“IBM converted past debt issues into Swiss francs and Deutsche marks from IBM into dollars.
The swap allowed IBM to take advantage of the rise in the dollar in the early 1980s and set the exchange rate at which to repay its debt.
For its part, the World Bank issued dollar bonds that provided it with the necessary dollars for the swap, and in exchange obtained financing in Swiss francs and marks. ” (Ibid.).
Commodity swaps
A classic financial problem is producer financing through raw materials, as world commodity markets are often highly volatile.
For example, international oil prices in a few days can drop up to 30%.
For this reason, the companies that produce raw materials are generally high-risk companies, both for loans and investments.
Therefore, these types of swaps are designed to eliminate price risk and in this way achieve lower cost of financing.
The operation of a commodity swap is very similar to that of an interest rate swap, for example: a three-year swap on oil; This transaction is an exchange of money based on the price of oil (A does not deliver oil to B at any time), therefore the swap is responsible for compensating any difference between the variable market price and the fixed price established through the swap.
That is, if the price of oil falls below the established price, B pays A the difference, and if it rises, A pays B the difference.
Stock index swaps
These allow you to exchange the performance of the money market for the performance of a stock market.
This stock return refers to the sum of dividends received, capital gains and / or losses.
Example on a nominal of USD 100 MM: “At the beginning of the swap, the initial value of the index in question is noted, for example, the value of the S&P 500 at the beginning of the period could be 410.00.
Every quarter A pays B three-month LIBOR in dollars over USD 100 MM. In turn, B pays A each quarter an amount of money equal to the dividends that A would have received had he invested USD 100 MM in the shares that make up the S&P 500, the index being at its initial value of 410.00 at the time from the investment.
In addition to the above, if the S&P 500 index is above its initial value at the end of the first quarter, B will pay A the difference on a number of shares corresponding to the initial investment of USD 100 MM with the index at 410.00, and if it is below A it will pay B the difference. This process is repeated every quarter, always taking the end of the previous quarter as a difference but keeping the number of shares defined at the beginning of the transaction always fixed ”. (Op. Cit.).
Through this mechanism, the same return is obtained from having invested in shares and is financed in turn, but always conserving your capital, and this allows you to invest it in other assets.
Credit swaps
These types of swaps serve to manage credit risk through the measurement and determination of the price of each of the underlying assets (interest rate, term, currency and credit).
These risks can be transferred to a holder more efficiently, thus allowing access to credit at a lower cost. Adjusting to the relationship between supply and demand of credit.
It could be said that credit risk is nothing more than a possible default risk.
There are two options for swaps: the default swap and the total return swap.
“In a default swap contract, a credit risk seller pays another party for the right to receive a payment in the event of the mutually agreed change in the credit status of the reference credit, usually a corporate title.
Total return swaps, by contrast, allow the seller of credit risk to retain the asset and receive a return that fluctuates as credit risk changes.
The seller pays full rates of return on a reference asset, generally a security that includes any consideration of price, in exchange for periodic floating rate payments plus any price reductions. ” (McDermott, 1999).
When these types of swaps were invented, they were usually used only by banks to protect bank loans.
Currently, they have become very popular hedging instruments since they allow the asset to be retained and in turn segment and distribute the risk.
This allows “a bank to free credit lines and continue lending money to its customers, even when it exceeds its exposure limits for said company or industry, by downloading the credit risk (in whole or in part) through a swap. total return or default.
In addition, you can focus on lending to the sectors where you have the greatest presence or experience, without worrying about excessive risk concentration.
Smaller banks, whose margins are reduced due to the high cost of money, could obtain a higher return and exposure to better credits using credit derivatives and not direct loans ”. (Op. Cit.).
Bibliography
MONROY, Arturo (2001). "Derivative Market Instruments"; Article taken from the Mercado de Valores magazine, monthly publication, September, Mexico.
RODRÍGUEZ, by Castro J. (1997). Introduction to Analysis of Financial Derivative Products. 2nd Edition, Editorial Limusa, México.
HULL, John (1996). Introduction to Futures and Options Markets. Editorial Prentice Hall, Spain.
McDERMOTT, Robert (1999). "The Expected Arrival of Credit Derivatives". Article taken from the magazine Ejecutivos de Finanzas, monthly publication, Year XXVIII, May, No.5, Mexico.
