In
finance, a swap is a derivative in which two counterparties agree to exchange
one stream of cash flows against another stream. These
streams are called the legs of the swap. The cash
flows are calculated over a notional principal amount,
which is usually not exchanged between counterparties.
Consequently, swaps can be used to create unfunded exposures
to an underlying asset, since counterparties can earn
the profit or loss from movements in price without having
to post the notional amount in cash or collateral.
Swaps
can be used to hedge certain risks such as interest rate risk, or to speculate
on changes in the underlying prices.
Structure
Most
swaps are traded Over The Counter (OTC), "tailormade" for the counterparties.
Some types of swaps are also exchanged on futures markets,
for instance Chicago Mercantile Exchange Holdings Inc.,
the largest U.S. futures market, the Chicago Board Options
Exchange and Frankfurtbased Eurex AG. David Swensen,
a Yale Ph.D. at Salomon Brothers, engineered the first
swap transaction according to "When Genius Failed: The
Rise and Fall of LongTerm Capital Management" by Roger
Lowenstein.
The
five generic types of swaps, in order of their quantitative
importance, are: interest rate swaps, currency swaps,
credit swaps, commodity swaps and equity swaps.
The
Bank for International Settlements (BIS) publishes statistics
on the notional amounts outstanding in the OTC Derivatives
market. At the end of 2006, this was USD 415.2 trillion
(that is, more than 8.5 times the 2006 gross world product).
The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency
as:

Notional outstanding
in USD trillion 
Currency 
End 2000 
End 2001 
End 2002 
End 2003 
End 2004 
End 2005 
End 2006 
Euro 
16.6 
20.9 
31.5 
44.7 
59.3 
81.4 
112.1 
US dollar 
13.0 
18.9 
23.7 
33.4 
44.8 
74.4 
97.6 
Japanese yen 
11.1 
10.1 
12.8 
17.4 
21.5 
25.6 
38.0 
Pound sterling 
4.0 
5.0 
6.2 
7.9 
11.6 
15.1 
22.3 
Swiss franc 
1.1 
1.2 
1.5 
2.0 
2.7 
3.3 
3.5 
Total 
48.8 
58.9 
79.2 
111.2 
147.4 
212.0 
292.0 
 Source:
"The Global OTC Derivatives Market at endDecember 2004",
BIS, [1], "OTC Derivatives
Market Activity in the Second Half of 2006", BIS,
[2]
Usually,
at least one of the legs has a rate that is variable.
It can depend on a reference rate, the total return of
a swap, an economic statistic, etc. The most important
criterion is that it comes from an independent third party,
to avoid any conflict of interest. For instance, LIBOR
is published by the British Bankers Association, an independent
trade body.
Example
Take
the case of a plain vanilla fixedtofloating
interest rate swap. Here party A makes periodic interest
payments to party B based on a variable interest
rate of LIBOR +50 basis points.
Party
B in turn makes periodic interest payments based on a
fixed rate of 3%. The payments are calculated over the
notional amount. The first rate is called variable,
because it is reset at the beginning of each interest
calculation period to the then current reference rate,
such as LIBOR.
Total
return swap

A
total return swap is a swap in which party A pays
the total return of an asset, and party B makes
periodic interest payments. The total return is
the capital gain or loss, plus any interest or dividend
payments. Note that if the total return is negative, then
party A receives this amount from party B. The parties
have exposure to the return of the underlying stock or
index, without having to hold the underlying assets. The
profit or loss of party B is the same for him as actually
owning the underlying asset.
Total
return swap (also known as total rate of return swap,
or TRORS) is a contract in which one party receives interest
payments on a reference asset plus any capital gains and
losses over the payment period, while the other receives
a specified fixed or floating cash flow unrelated to the
credit worthiness of the reference asset, especially where
the payments are based on the same notional amount. The
reference asset may be any asset, index, or basket of
assets.
The
TRORS, then, allows one party to derive the economic benefit
of owning an asset without putting that asset on its balance
sheet, and allows the other (which does retain that asset
on its balance sheet) to buy protection against a potential
decline in its value.
The
essential difference between a TRORS and a credit default
swap is that the latter provides protection not against
loss in asset value but against specific credit events.
In a sense, a TRORS isn't a credit derivative at all,
in the sense that a CDS is. A TRORS is fundingcost arbitrage.
Equity
Swap

An
equity swap is a special type of total return swap,
where the underlying asset is a stock, a basket of stocks,
or a stock index. Compared to actually owning the stock,
in this case you do not have to pay anything up front,
but you do not have any voting or other rights that stock
holders do have.
Valuation
The
value of a swap is the net present value (NPV) of all
future cash flows. Initially, the terms of a swap contract
are such that the NPV of all future cash flows is equal
to zero.
For
example, consider a plain vanilla fixedtofloating interest
rate swap where Party A pays a fixed rate, and Party B
pays a floating rate. In such an agreement the fixed
rate would be such that the present value of future
fixed rate payments by Party A are equal to the present
value of the expected future floating rate payments
(i.e. the NPV is zero). Where this is not the case, an
Arbitrageur, C, could:
 assume
the position with the lower present value of
payments, and borrow funds equal to this present value
 meet
the cash flow obligations on the position by using the
borrowed funds, and receive the corresponding payments
 which have a higher present value
 use
the received payments to repay the debt on the borrowed
funds
 pocket
the difference  where the difference between the present
value of the loan and the present value of the inflows
is the arbitrage profit.
Variations
Variations
of swaps include cross currency swaps, amortizing swaps
and so on.
Options
An
option on a swap is called a swaption.
References
 Financial
Institutions Management, Saunders A. & Cornett M.,
McGrawHill Irwin 2006
External
links