What is a Swap?
In my last post “What is a Derivative” I stopped before we discussed Swaps. The reason for this is Swaps can get pretty confusing if we don’t take the time to thoroughly discuss the nuances that are inherent in a Swap contract.
The most common definition of a Swap Contract is an agreement between two parties to exchange a series of cash flows related to an underlying asset or another financial asset. The most common application of a Swap Contract is applied to Foreign Currency (FX) or interest rates (Rates.)
Similar to Forward Contracts – Swaps are executed in Over-the-Counter markets, thus they are customizable to whatever terms the parties involved the transaction agree to.
Acme, Inc. (the company) manufactures and distributes rockets for personal use. Last year the company issued $3 Billion 10 year floating rate bonds to fund a new production facility where they plan to manufacture their newest rocket, The Roadrunner. This year is an election year and one of the candidate’s agendas could push interest rates higher, thus increasing Acme’s interest expense on the bonds. Acme’s CFO believes the best course of action is to enter a Swap Contract to hedge their interest rate risk.
After calling around to a number of investment banks, Acme finds a counterparty (the bank) that has agreed to enter a Swap Contract. The Swap has a notional value of $3 Billion and a tenor of 9 years. Essentially, Acme will swap their floating rate payment for a fixed payment. Acme will pay the bank a fixed rate and they will receive a floating payment. If interest rates increase, as Acme expects, the bank will pay Acme the difference in the fixed rate and the floating rate. Here you can see Acme’s net cash outflow will equal the payment on the floating rate bonds, mins the cash inflow from the Swap.
Why do people use derivatives?
If you think back to our discussion of Futures and Forwards, you will remember that we employed a strategy related to our belief that the future value of the underlying will be different than it is today, such an application of derivative instruments speaks to the first use of derivatives speculation. When a trader enters a contract with speculative goals they intend to profit from prices movements in the underlying. The other use of derivatives is for risk management or hedging. Hedging refers to the use of a financial instrument that will offset gains or losses incurred due to the price appreciation or depreciation of some underlying financial instrument or some other financial obligation, such as interest payments on outstanding debt in our example of Swaps.
You might be asking yourself why an agreement like this would be worth it. Think of the old saying – “A bird in the hand is worth two in the bush.” By entering the Swap Acme has effectively limited the volatility of their required debt payments which many consider more valuable than the possible benefit from volatility (falling interest rates) of the required payments. The certainty of cash outflows is extremely valuable to company managers and many will go to extraordinary lengths to limit the volatility of cash outflows.
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Thanks for reading!