This is part 5 of a 10 part series on currency swaps and interest rate swaps and their role in the global economy. In parts 1 through 4, we discussed the differences between interest rate swaps and currency swaps, as well as the pricing mechanisms for fixed-for-floating, floating-for-floating, and fixed-for-fixed swaps. In part 5, we’ll review the basics before looking at some real world examples in parts 6 and 7.

We’ve fielded some basic questions on interest rate swaps and will provide some clear, succinct answers to make this complex financial instrument a little more understandable.

Let’s start with a basic swap

What is a swap?

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.

What is the most common type of swap?

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. Currency swaps, sometimes referred to as cross-currency swaps, are also very common, especially in the realm of international financing.

I only recently heard of swaps, how long have they been around for?

The first swap, a currency swap, was a $290 million agreement between the World Bank and IBM, in 1981.

How big is the swap market now?

As the world’s deepest financial derivatives market, the over-the-counter (OTC) swaps market has a notional value of $415.2 trillion as of 2006, according to the Bank of International Settlements (sometimes referred to as the central bank for central banks). At that figure, in 2006 dollars, that would make the swaps market approximately 8.5 times the size of global GDP – combined!

Over-the-counter, what does that mean?

Over-the-counter, or OTC, is off-exchange trading of financial instruments, not just swaps, but stocks, bonds, and commodities as well, directly between parties. While most of the swaps market is OTC, meaning it is without a centralized exchange, interest rate swaps can be standardized contracts regulated by exchanges, like futures.

Who uses swaps?

Swaps are utilized by two groups of people: hedgers and speculators. Bona fide hedgers are using swaps to insulate themselves from future risk, whereas speculators are without hedging need and are in the market for the sake of making money. Under CFTC Regulation 1.3(z), no transactions or position will be classified as bona fide hedging unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices.

So bona fide hedgers come from futures trading?

No! Actually, the first hedge exemption was granted by the CFTC to a swaps dealer for OTC index-based exposure where the swaps dealer writing the swap establishes a futures position to hedge its price exposure on the swap. Sounds complicated, but really, the swaps dealer proved he was protecting his capital rather than using it to speculate on swaps.

I have a fixed rate but I really want a floating rate – what do I do?

If your financing is within your borders and you are using your domestic currency, a domestic fixed-for-floating swap is the type of swap you would initiate with another party. This is known as a plain vanilla swap (see above), and is the most common type of swap.

But I’m not using these funds in my country – I’m funding a project aboard

In this case, this would be a fixed-for-floating currency swap, or a cross-currency swap, and it would require a counterparty in the country in which you’re seeking to finance a project.

I remember where I’ve heard swaps before – didn’t Greece get in trouble with swaps?

This is a complicated subject but we will cover it extensively in part 8 of this series.

In part 6 of 10 of this series, we will lay out simple real world examples of how companies would use swaps to hedge against risk in domestic projects as well as projects abroad.