Swap

Definition

A swap is an over-the-counter derivatives agreement between two counterparties to exchange a series of cashflows at agreed dates.

A Little Bit More

The swap agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated. Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate, or other market variable.

A forward contract can be viewed as a simple example of a swap. Suppose it is March 1, 2017, and a company enters into a forward contract to buy 100 ounces of gold for $1,200 per ounce in one year. The company can sell the gold in one year as soon as it is received. The forward contract is therefore equivalent to a swap where the company agrees that on March 1, 2018, it will pay $120,000 and receive 100S, where S is the market price of one ounce of gold on that date.

Whereas a forward contract is equivalent to the exchange of cash flows on just one future date, swaps typically lead to cash-flow exchanges taking place on several future dates.

Basics

There are three common types of swaps: interest rate swap, currency swap and equity swap.

History

The birth of the over-the-counter swap market can be traced to a currency swap negotiated between IBM and the World Bank in 1981. The World Bank had borrowings denominated in U.S. dollars while IBM had borrowings denominated in German deutsche marks and Swiss francs. The World Bank (which was restricted in the deutsche mark and Swiss franc borrowing it could do directly) agreed to make interest payments
on IBM’s borrowings while IBM in return agreed to make interest payments on the World Bank’s borrowings. Since that first transaction in 1981, the swap market has seen phenomenal growth.

Valuating Swaps

When valuing swaps, we require a ‘‘risk-free’’ discount rate for cash flows. Prior to the 2008 crisis, LIBOR was used as a proxy for the risk-free discount rate. Since the 2008 credit crisis, the market has switched to using the OIS rate for discounting.

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