8/4/2019 How Many Types of Swaps Are There

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How many types of swaps are there?

Forward swap It is also known as delayed start swap,forward start swap or deferred start swap and is a kind of swapagreement that is often valued with two different and partialoffsetting swaps and both the swaps starts immediately. But oneof them ends on the date of the start of the other one known asforward swap. This swap is specially designed for the timingconvenience of the investors.

Total return swap it is the most widely used form of swap inphysical commodities market or in case of equity market. It is akind of swap agreement that allows one party to pay accordingto a fixed rate or according to a variable rate. But, the other partyonly pays according to the returns it gets from the underlyingassets like loans, bonds, etc. and includes the generated incomefrom and the capital gains of the underlying assts.

Currency swap it is the kind of swap with the help of whichall of the principal amount as well as the interest on that amountof a particular currency can be swapped with another currencyand it is free of any kind of exchange rules.

Circus swap it also termed as currency coupon swap or cross-currency swap and includes the characteristics of both thecurrency swap as well as of the interest rate swap. Under thisswap a loan of fixed rate of a particular currency can be replacedwith a loan of floating rate of some other currency.

Commodity swap this is a kind of swap under which all ofthe cash transactions are the result of the underlying commodityand hence called commodity swap. Through this swap aninstitution gets a fixed price from the commodity user andmarket price from the commodity producer. The financialinstitution in return facilitates the required needs of both theparties.

Asset swap Under this swap agreement, only the floating orthe fixed investments are swapped but not the fixed or floatinginterest rates and this swap is almost similar to the plain vanillaswap except the underlying swap contract.

Interest rate swap it is the kind of swap agreement betweentwo companies or banks to switch over a floating rate loan into afixed rate loan or vice versa in different countries. Thecurrencies into which the swap has taken place could be eithersame or different.

Constant maturity swap it is the kind of swappingagreement under which a buyer has the right to set its own timeduration for the received flows on a particular swap. It can oftwo different types termed as cross-currency swap or singlecurrency swap. This swap allows the readjustment of a part ofthe interest rate periodically based on the fixed maturity rate ofthe market and it is a variant form of interest rate swap. But itcannot be readjusted with any floating reference index rate.

Basic rate swap Generally, due to different rates ofborrowing and lending, companies run the risk of interest rate,which is neutralized with the help of basic rate swap. It enables

the two parties involved in the agreement to exchange interest rates varying according to money markets.

Variance swap It is a variant of the volatility swap and undthis swap the linearity of variance go along with the payout, nwith the volatility as in the case of volatility swap. Tdifference makes the payout as the one with higher rates, not tvolatility.

Overnight index swap it simply involves the swapping o

fixed interest rate to an overnight rate.

Zero basic rate also known as Zebra swap, actual rate swor perfect swap and is a swap agreement between a financintermediary and a municipality. Under this swap agreement, financial intermediary receives from the municipality a floatirate of interest and pays to the municipality a fixed rate interest.

Roller coaster swap it is a kind of seasonal swap that gcreated for meeting the periodical financial requirements of tcounter-party and provides some liberty in terms of paymeaccording to the periods set beforehand. So if a company

dealing in some commodity, which has its demand seasonalthen the company will surely go for a roller coaster swap.

Airbag swap this swap gets created to counter the effects fluctuating interest rates that puts a negative pressure on tinvestment. This counter effect is achieved through adjustment of the notional value of the fluctuating interest rby indexing the very part of the interest rate that is fluctuatinga constant maturity swap.

Advantages of swaps

1. Borrowing at Lower Cost:

Swap facilitates borrowings at lower cost. It works on tprinciple of the theory of comparative cost as propounded Ricardo. One borrower exchanges the comparative advantapossessed by him with the comparative advantage possessed the other borrower. The net result is that both the parties are abto get funds at cheaper rates.

2. Access to New Financial Markets:

Swap is used to have access to new financial markets for funby exploring the comparative advantage possessed by the ot

party in that market. Thus, the comparative advantage possessby parties is fully exploited through swap. Hence, funds can obtained from the best possible source at cheaper rates.

3. Hedging of Risk:

Swap cal also be used to hedge risk. For instance, a company hissued fixed rate bonds. It strongly feels that the interest rate wdecline in future due to some changes in the economic scene. Sto get the benefit in future from the fall in interest rate, it hasexchange the fixed rate obligation with floating rate obligatioThat is to say, the company has to enter into swap agreemewith a counterparty, whereby, it has to receive fixed rate inter

8/4/2019 How Many Types of Swaps Are There

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and pay floating rate interest. The net result is that the companywill have to pay only floating rate of interest. The fixed rate ithas to pay is compensated by the fixed rate it receives from thecounterparty. Thus, risks due to fluctuations in interest rate canbe overcome through swap agreements. Similar, agreements canbe entered into for currencies also.

4. Tool to correct Asset-Liability Mismatch:

Swap can be profitably used to manage asset-liability mismatch.

For example, a bank has acquired a fixed rate bearing asset onthe one hand and a floating rate of interest bearing liability onthe other hand. In case the interest rate goes up, the bank wouldbe much affected because with the increase in interest rate, thebank has to pay more interest. This is so because, the interestpayment is based on the floating rate. But, the interest receiptwill not go up, since, the receipt is based on the fixed rate. Now,the asset- liability mismatch emerges. This can be convenientlymanaged by swap. If the bank feels that the interest rate wouldgo up, it has to simply swap the fixed rate with the floating rateof interest. It means that the bank should find a counterpartywho is willing to receive a fixed rate interest in exchange for afloating rate. Now, the receipt of fixed rate of interest by the

bank is exactly matched with the payment of fixed rate interestto swap counterparty. Similarly, the receipt of floating rate ofinterest from the swap counterparty is exactly matched with thepayment of floating interest rate on liabilities. Thus, swap isused as a tool to correct any asset- liability mismatch in interestrates in future.

5. Additional Income:

By arranging swaps, financial intermediaries can earn additionalincome in the form of brokerage.

The Disadvantages of Interest Rate Swaps

Interest rate swaps are a financial tool used by largeinvestors.

Interest rate swaps are a financial mechanism used byinvestors to manage risk and speculate on future marketperformance. In a rate swap, one investor group pledgesto pay a fixed interest rate on an investment to anotherin return for a variable interest rate on the same amountof money. This allows speculators to help otherinvestors solidify their investments.

Rate Increases for Investigators

1. Because the return on investments with floating interestrates fluctuates with the market, theyre more difficultto manage than fixed-rate investments. Moneymanagers frequently swap floating rates for fixed ratesin a rate swap in order to lock in a rate and allow forplanning. If the floating interest rate rises after terms ofthe rate swap are negotiated, the original interest-streamowner loses out on the increased interest revenue fromboosted rates, but only in the difference between the

rate agreed upon with the other party in the swap athe floating one. For example, if a rate-swap negotiated at 6.7 percent interest, and the floating rrises to 6.9 percent, the original investor doesnt accrinterest for the 0.2 percent difference in rates.

Rate Drops for Speculators

2. Speculative investors trade the predictability asecurity of fixed interest rate revenue streams for t

volatility of floating rate streams predicting interrates will rise, making the floating rate more lucratiand the investment worth more than the initial outlaythe floating rate falls, the value of the speculatoinvestment decreases, and the investor loses money. Fexample, trading a $1,000 at 6.5 percent interest rrevenue stream (worth $65 annually) for a $1,0floating rate stream that drops to 6 percent (worth $annually) results in a net loss of $5 annually for tspeculator.

Currency Fluctuations

3. More complicated forms of rate swap mechanisms travalue in two currencies or a combination of interrates and currencies. These strategies pose the sarisks to investigators and speculators--either losing oon additional revenue when the value of one currenrises or losing money when it falls--the combinationcurrency exchange and interest rate prediction makinternational rate swaps a complicated proposition.