A swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.
The objective of a swap is to change one scheme of payments into another one of a different nature, which is more suitable to the needs or objectives of the parties, who could be retail clients, investors, or large companies.
An individual client could, for example, decide to make a swap to exchange the variable payments on a mortgage, which are linked to the Euribor (Euro Interbank Offered Rate), for payments at a fixed interest rate. In this way, the risk of unexpected increases in monthly payments would be averted.
Large companies finance themselves by issuing debt bonds, on which they pay a fixed interest rate to investors. On many occasions, they contract a swap to transform those fixed payments into variable rate payments, which are linked to market interest rates. The reasons for doing so are many, and are generally intended to optimize the company’s debt structure.
Likewise, a swap can also be useful for a company that has issued bonds in a foreign currency and wants to convert those payments into local currency by contracting a cross-currency swap. Currency swaps may be made because a company receives a loan or revenues in a foreign currency, which must be changed into local currency, or vice-versa.
The objective of a swap is to change one scheme of payments into another one of a different nature.
A swap is defined technically in function of the following factors:
- The start and end dates of the swap.
- Nominal: The amount upon which the payments of both parties are calculated.
- Interest rate or margin of each of the contracting parties.
- Index of reference for the variable part.
- Periodicity or frequency of payment.
Calculation base of each party: the way in which interest payments are calculated, basically defining how the days between the two dates are counted.
In the most common type of swap, a fixed interest rate is paid in exchange for receiving a variable rate. This variable rate is linked to a reference rate; in Europe, the Euribor is the most common one.
The market for swaps
The market for swaps represents 80% of the global derivatives market and amounted to $320 trillion at the end of 2015. Since these products are generally adapted to the needs of the client and not easily standardized, so as to be traded on an exchange, the swap market has always been considered an Over the Counter Market. However, the swap market is one of the largest, most liquid and most competitive in the world.
In spite of these characteristics, it has not escaped digitization in recent years and a large percentage of the most common contracts are negotiated electronically through platforms such as Bloomberg, Tradeweb or individual brokers’ platforms.
The swap market is undergoing a process of important regulatory changes, in an effort to provide greater transparency and access to information, and to reduce systemic risk.