Introduction to Swaps

Swaps are private over the counter agreements that are largely unregulated; swaps can be highly customized to meet the needs of the counterparties.

A swap is a mutually agreed exchange of cash flows.

A swap has an initial value of zero; with the passage of time and change of market conditions, the swap may have negative value for one party and positive value for the other party. The party with positive value is exposed to default risk by the party with negative value.

No money is exchanged at swap initiation, with the exception of currency swaps.

Swaps can be categorized as: currency, interest rate, equity (including equity index), and “commodity & other” swaps.

Swap Terminology

• Counterparties: The two swap participants
• Notional Principal: Money amount used as part of the calculation in determining the amount of the payment
• Standard (or Plain Vanilla) Interest Rate Swap: One counter party is pay fixed/receive floating and the other counter party is receive fixed/pay floating.
• Term/Tenor/Maturity/Expiration: Length of time over which payment exchanges will take place.

Early Exit of a Swap

A counterparty can make an early exit from a swap contract in one of the following ways:

• Negotiate a termination agreement with the other counterparty.  Note that the other counterparty may not be willing to cancel the swap.
• Locate a new counterparty and enter into an economically offsetting swap position with this other counterparty.  Note that while the new swap may offset market risk, the party seeking to terminate the initial swap now has counterparty risk exposure to two counterparties.
• Sell the swap to a new party.  Note that the original counterparty to the “would be” seller must approve the swap sale.  This is a rare exit strategy.
• Purchase a swaption that will enter into a swap that economically offsets the original swap.