What is a swap?
A swap is a derivative in which two parties exchange financial instruments, in most cases involving cash flows between them. These cash flows are calculated over a notional principal amount. Each cash flow is commonly referred as a “leg” of the swap.
Generally, one cash flow will be fixed, while the other will be variable or floating (eg, interest rate, index price or currency exchange). The interest rate swap is the most popular and the biggest swap market. Unlike stocks, bonds or other traditional securities, swaps are not traded in exchanges but as tailored “over-the-counter” contracts.
History of the swap market
The first swap agreement entered in 1981 between IBM and the World Bank. In the following decades the different types of swaps were developed and consolidated. However, it was not until 2001, when the dotcom bubble burst, that the swap market won massive capitalisation.
In the years previous to the 2008 financial crisis, the swap market capitalisation increased over six-fold, reaching an estimated £250 trillion by 2006. This figure is 8.5 times the 2006 gross world product.
Types of swaps
There are many kinds of swaps, but they can be grouped in five generic categories:
Interest rate swaps: by far the most common type of swap. This market is fuelled by the differences in interest rates between central banks. Hence, some companies may have a comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets.
Currency swaps: a currency swap occurs when exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.
Credit default swaps: known as CDS, these are credit derivative contracts between two parties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event.
Commodity swaps: a commodity swap is an agreement where a floating price is exchanged for a fixed price over a specified period of time. Most of the commodity swaps are related to oil or oil sub-products.
Equity swaps: a contract in which the equity holder, or buyer, pays a premium to the seller (silent holder) for the option to transfer certain risks.
Category: Financial Glossary