The financial market is ever-expanding and evolving. Newer ways to invest via different schemes and instruments have cropped up, expanding the scope for diversification of your portfolio. Apart from equity, derivatives are also a great way to invest and make profits. One such derivative is called a ‘swap contract’.
Let us see how various players in the market use swap contracts.
Swaps are derivative contracts made for a financial exchange between two parties. The two said parties agree to exchange the earnings on two separate financial instruments. Moreover, only the cash flows are exchanged, whereas the principal amount invested remains with the original parties. Every cash flow exchange is known as a ‘leg’.
Swap contracts involve an underlying asset, which can be any legal commodity or financial instrument of value. It is usually the big businesses and financial institutions that enter into such contracts. However, swap transactions are not prevalent among retail investors.
Unlike shares traded on a stock exchange in a dematerialised format, swaps are over-the-counter transactions.
For a swap contract, there is no standardised format that is followed. Each contract is unique and tailor-made. After negotiating, the parties enter into a contract based on the conditions that they both agree to.
A swap contract is based on a notional principal amount. The cash flows earned on it are exchanged between the parties. Moreover, the swap contract specifies a start and end date. The exchange of cash flows takes place during this period at specified frequencies.
Since these are traded over the counter, there is no mechanism to oversee these deals. This increases the chances of counterparty defaults, making them risky contracts to enter into.
Different kinds of swap deals operate differently. Moreover, each kind of swap has a particular purpose.
This is the most common type of swap contract, wherein, the fixed exchange rate is swapped for a floating exchange rate. For instance, X and Y enter into an interest rate swap. Here, X agrees to pay Y an interest at a predetermined fixed rate. In exchange, Y pays X interest at a floating rate. These interest payments are made at specified intervals throughout the contract’s duration. It allows the parties to hedge against the risk that arises from interest rate fluctuations. This is also known as a plain vanilla swap.
In most cases, producers enter into a swap with buyers and fix a selling price for the commodity. This helps them mitigate the losses that may arise from fluctuations in price. The underlying asset in such a swap can be any commodity, including grains, crude oil, and metals. The value of such commodities is determined at a spot price, which can be highly volatile.
This type of swap works like insurance for a lender against the risk of default by the borrower. Here, a third-party guarantees to pay the principal as well as the interest to the lender if the borrower is unable to repay. It reduces the risk undertaken by the lender and allows the borrower to avail of loans more easily. However, the swap contract only comes into action if the borrower defaults.
This swap is used to exchange debt for equity or vice versa. It is a method employed to restructure the capital of a company. In many cases, companies do so when they are unable to pay their dues on the debt they have undertaken. Shifting to equity allows them to push the repayment.
Total return swaps involve one party providing interest at a fixed rate to the other party. For example, A owns shares that are exposed to price fluctuations and other benefits such as dividends. He enters into a swap contract with B. B agrees to provide A a fixed interest. This reduces A’s risk as he gets a stable return. In exchange, B benefits from the price fluctuations, dividends, and appreciation of the share’s value.
Currency swaps involve a loan amount, interest on which is exchanged by the two parties. This amount is in separate currencies. Many businesses use this to avoid foreign exchange taxes and get easy loans in a local currency. Governments also enter into such contracts to stabilize exchange rate fluctuations.
Another example of such a swap is the dollar-rupee swap auction announced by the RBI recently.
The RBI used a dollar-rupee swap as a tool to manage the forex market’s liquidity and stabilize the value of the rupee. The Central Bank announced a six-month swap window to conduct this activity.
RBI announced that it would give $2 billion (in return for the Indian rupee) to banks that wish to enter the swap. This would infuse dollars into the market and improve its liquidity. Moreover, banks that had a major outflow of dollars would be able to replenish their reserves.
However, it was a sell-buy swap deal. This means that at the same time, the two parties also entered into a deal where this transaction would be reversed after six months. The banks would have to sell the US dollars for INR to the RBI, who promised to buy it from them.
This move was taken in an effort to normalize the effects of global turmoil and to minimize its impact on the Indian financial markets.
Swaps can help the party reduce the risk that comes with fluctuations in the market. Moreover, a commodity swap reduces the risk for the producer as it ensures a specified amount to them, even if the prices go down.
Swaps allow the market players to venture into markets they previously could not access. It can be utilized to approach new financial markets as hedging allows you to reduce your risk.
The takeaway
Swaps are financial derivatives that are generally used by big businesses and financial institutions. A swap contract involves the exchange of cash flows from an underlying asset. The major benefit of swaps is that it allows investors to hedge their risk while also allowing them to explore new markets.