There are two main types of interest rate swaps, currency swaps and interest rate swaps. Although there are many other variations – including the more recently popular commodity swaps and credit default swaps – this series will concentrate on the main two types. Since 1981, the swaps market has grown into the largest financial derivatives market in the world, with trillions of funds in use today.
What is a ‘swap’?
Broadly speaking, a swap is a financial derivative in which two parties (called counterparties) exchange future cash flows of the first party’s financial instrument for the future cash flows of the second party’s financial instruments. The most common type of swap is a plain vanilla swap, or an interest rate swap, and is when one party exchanges its fixed rate obligation with a second party’s floating rate obligation. Why would two parties want to exchange future cash flow obligations?
Typically, swaps occur when the two parties have differing interest rate forecasts. For example, if the party holding the floating rate instrument believes rates will increase in the short-term while the party holding the fixed rate instrument believes rates will decrease in the short-term, they might swap obligations.
Let’s be clear – both parties are seeking a comparative advantage, hence the desire to swap obligations. When borrowing money, a party wants to seek the lowest possible borrowing rate in order to reduce future payments. In some conditions – like those experienced by the World Bank in 1981 – a party does not always find itself borrowing in its desired environment, i.e., when it seeks to borrow at a floating rate but can only finance at a fixed rate. In parts 3 and 4, we’ll dive into specific examples of interest rate swaps and how they’re calculated.
Currency swaps not vanilla
Currency swaps differ slightly from plain vanilla swaps or interest rate swaps. A currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the U.S. Dollar) for principal interest and fixed interest in another currency (i.e. the Euro). Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.
Hedging against exchange rate risks is vital to companies in the global market. For example, if a U.S. company is selling products in Germany, it receives payments for those goods in Euros. If the value of the Euro plummets while those goods are being sold, then it loses potential profit. To hedge against this type of risk, that company might sell Euro futures. That way, any value that the Euro loses that could hurt revenue is insulated by the offsetting position in the futures market.
The purpose of currency swaps is similar to that of futures: to limit risk from international financial transactions. Interested in learning more? Check out our eBook on Interest Rate Swaps for Smart People.