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What Is Swaps

A swap is a derivative contract where two parties exchange cash flows from different financial instruments, such as one party paying a fixed interest rate in exchange for a floating rate. A fixed-for-floating swap specifically exchanges the cash flows of fixed-rate loans for floating-rate loans. Counterparty risk refers to the risk that the other party in a transaction cannot meet their obligations, such as defaulting on coupon or principal payments. Counterparty risk is important because it is present in many financial market transactions and large institutional investors take it on through derivatives like interest rate swaps, which are primarily traded over-the-counter.

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29 views

What Is Swaps

A swap is a derivative contract where two parties exchange cash flows from different financial instruments, such as one party paying a fixed interest rate in exchange for a floating rate. A fixed-for-floating swap specifically exchanges the cash flows of fixed-rate loans for floating-rate loans. Counterparty risk refers to the risk that the other party in a transaction cannot meet their obligations, such as defaulting on coupon or principal payments. Counterparty risk is important because it is present in many financial market transactions and large institutional investors take it on through derivatives like interest rate swaps, which are primarily traded over-the-counter.

Uploaded by

amit sahani
Copyright
© © All Rights Reserved
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Download as DOCX, PDF, TXT or read online on Scribd
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What Is swaps?

A swap is a derivative contract through which two parties exchange the cash flows or
liabilities from two different financial instruments. ... Rather, swaps are over-the-counter
contracts primarily between businesses or financial institutions that are customized to the
needs of both parties
What is fixed and floating swap?
A fixed-for-floating swap is a contractual arrangement between two parties in which one
party swaps the interest cash flows of fixed-rate loan(s) with those of floating-rate loan(s)
held by another party. The principal of the underlying loans is not exchanged.

What is counterparty risk?

Counterparty risk (also referred to as credit risk or default risk) is the risk that your
counterparty in a transaction cannot honour its obligation to you. For example, you
have bought a corporate bond from company XYZ, expecting to receive coupon
payments and the nominal value of the bond at maturity. Under this transaction, you
are exposed to the risk that XYZ can’t pay you the coupons and principal at the
agreed point in time.

Why is counterparty risk important ?

Counterparty risk is widely present in financial markets, and is a risk experienced by


all sorts of investors, both large and small. For example, all investors in bonds (or
any other type of loan) take on a certain amount of counterparty risk, especially
when investing in corporate bonds. Most fixed income investors are aware of this
and are actually making an informed decision to take on this extra credit risk in return
for higher yields.

Large institutional investors are no strangers to counterparty risk, either. This


particular group of investors widely uses equity put options, swaps, swaptions and
inflation linked swaps to hedge their market risk. Almost all these transactions are
executed in the OTC market, simply because the listed market does not offer the
right type of hedging instruments for them. In the OTC market, (investment) banks
are taking on the other side of the transaction.

Hence, by nature, most large institutional investors have to cope with a great deal of
counterparty risk. As the fall of Lehman Brothers has illustrated, perceived protection
in reality will be worthless in case of a default of the hedge provider - unless you are
prepared and know how to deal with counterparty risk.

■ Coupon Swap:
■ In Coupon swap, one party makes payment at a fixed rate of interest in exchange for
receiving payments at a floating rate (which changes for each payment). The other party
pays the floating rate and receive the fixed rate.

■ Basis Swap:

■ In a basis swap, the parties exchange payments on one floating rate basis for payments on
another floating rate basis.

■ Point to be noted that, most Interest rate Swaps are coupon swaps.

Advantages of Swaps
 Swaps are flexible and the arrangements costs of swaps are
significantly less than terminating an existing loan and taking a
new one.
 Swaps allow capital restructuring by changing the nature of
interest commitments without renegotiating with lenders
 Swaps can be used to manage interest rate risk by swapping
floating for fixed rate debt if rates are expected to rise. Swaps
can also be used to swap a variable rate for a fixed rate
investments if interest rates are expected to fall.
 Swaps are relatively easy to manage
 If a company’s future cash flows are uncertain, it can use a
swap to ensure it has a periodical fixed rate commitments.

Risks of Swaps
Risk that counter party may default before completion of
Counter Party Risk
agreement

Position or Market Risk of unfavourable market movements of interest or


Risk exchange rates after the company enters a swap

Risk that swap activity may lead to accounts of party


Transperancy Risk
involved being misleads.

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