What are swaps?
A good friend asked a good question the other day:
[GoodFriend] : What are swaps?
Before talking about swaps, I’d like to preface this post by mentioning that Wikipedia, Investopedia, and other resources online/at your local library can certainly provide a more detailed, technical, and accurate explanation than I ever could. The amount of information on swaps is staggering, which might be a bit intimidating if you just want a bit of background knowledge. So with that in mind, I figured writing this blog post would help me consolidate and improve my own knowledge, while (hopefully) serving as a helpful resource for a casual reader!
With that in mind, we’ll answer the question at a high level by using three common examples of swaps:
- Interest rate swaps (IRS)
- Currency swaps (not to be confused with foreign exchange swaps which are a very different kind of swap)
- Credit default swaps (CDS)
First, a super vague and informal definition of a swap:
A swap is an agreement between two parties to exchange certain amounts of certain things at certain times in a certain period.
This definition doesn’t really help us though. To understand better what a swap is, it’s necessary to know why somebody would want to enter into such an agreement.
Typically, a party will want to enter a swap agreement in order to shield themselves from certain risks
Okay, that’s a bit better, but still a bit too general and abstract. What are the certain risks that we would like to protect ourselves against?
Each swap agreement described above is entered for the purpose of hedging against a different type of risk; respectively:
Cool! First let’s understand these risks (again, at a high level), then we can talk about how these swaps can protect us against these risks.
Interest Rate Risk
An interest rate, generally expressed as an annual percentage, is the cost of borrowing (if you’ve borrowed money) or the return on lending (if you’ve lent money).
So if you’re a Big Business Company and you want to take out a loan of 100,000 Currency from your local Bank of Money to spend on Business Expenses and repay in one year, you’ll need to pay an interest rate on that loan. Let’s say that the Bank of Money hands you a loan contract, and it says that in return for giving you this money today, you must pay a fixed (remember this word! It’s important!) 5% annual interest rate on the initial 100,000 (also called the principal). And so you sign the contract because you think 5% is fair (perhaps because all the other banks offered a similar deal, or perhaps 5% is close enough to a proxy for interest rates such as the US 1-year Treasury Bill yield (don’t worry if you don’t know what this is. You can consider it, for now, just as some percentage number that fluctuates over time)).
After you sign, you get your 100,000 Currency and start buying Business Equipment, keeping in mind that in one year, you’ll have to give the bank 105,000 Currency (100,000 from paying back the principal, plus 5% of the principal).
So a year goes by, and your Big Business Company has been making money using the Business Equipment that you had bought. Your loan contract says that now it’s time to pay up. 100,000 plus 5,000 Currency is hard to part with, but you signed the contract and thus, legally, you must honor it (to the best of your ability).
But wait! Interest rates change over time! You look at the interest rate on a one year loan at the Bank of Money, and you notice that if you take out another 100,000 Currency today, you would only have to pay an annual 4% interest rate. Sweet! The interest rate is 4% now, does that mean that you only have to pay 104,000 Currency today?
Nope. Remember how the contract you signed had a fixed interest rate of 5% per annum (meaning annually)? You’re stuck paying 105,000 Currency, my friend. Better shell out. You leave the Bank of Money, return to your Big Business Company, and continue doing Business Things while grumbling how fixed interest rate loans suck.
Now let’s look at your business rival who runs Evil Business Inc, who just walked into the Bank of Money to take out a 100,000 Currency loan in order to buy Evil Business Equipment. She asks for a floating rate loan because she thinks she’s clever. The Bank of Money obliges, and gives her a contract for a one year loan of a 100,000 Currency principal, with an annual interest rate pegged to the LIBOR + 0.50% (the LIBOR is the London Interbank Offered Rate, and it is one of those commonly quoted fluctuating interest rates out there.).
She quickly looks up the current 1 year LIBOR, and sees that it’s 3%. With the additional 0.50%, that’s only a 3.50% interest rate. That means that in a year, assuming LIBOR doesn’t change (but you, the reader, now probably know what’s coming next), she’ll only have to pay 103,500 Currency. She signs.
One year later, she comes back triumphantly to repay her debt of 100,000 + 3,500 Currency. But what’s this? The 1 year LIBOR has gone up from 3% to 5%! This means that instead of paying 103,500 Currency, she’ll have to pay 105,500 instead.
It should be pretty clear what the risk is here!
Interest rate risk is your exposure to changes in interest rates. Fixed rate loans are exposed to downward shifts in interest rates. Floating rate loans are exposed to upward shifts in interest rates. The converse is true if you are the party who is lending money.
Let’s see how Interest Rate Swaps can help us hedge against this risk.
Interest Rate Swaps
Remember how we had earlier defined a swap as an agreement to exchange certain things at certain periods in time? Well, we can use such an agreement to take advantage of decreases in interest rates, if we’re currently locked into a fixed rate contract.
Let’s say that in our previous case where you had a contract for 100,000 Currency at 5%, you believed that it is likely that interest rates are going to go down; specifically, the LIBOR. But you can’t change the terms of the contract, so you can form an agreement with someone else (any party who can agree to the following agreement and who has the opposite position of yours) that looks like this:
- You pay them LIBOR + 0.50% on some agreed upon amount (called the notional) every year. This notional amount generally doesn’t change hands; it’s just there so that we can express payments in percentages. Let’s say that this amount is 50,000 Currency.
- They pay you a fixed 4% on the notional every year.
Now, we have effectively hedged ourselves slightly against drops in the LIBOR. Let’s do some math!
Our original contract was for 100,000 Currency, to be paid in one year, at 5% fixed per annum.
We currently have agreed to pay floating-for-fixed, with the terms that we are to pay LIBOR + 0.50% and receive 4% on a notional amount of 50,000 Currency.
Let’s say that LIBOR, when the debt comes due, has fallen to 2.00%. Without this agreement, we would be stuck paying 105,000 Currency. But now that we have this interest rate swap, we now receive 4% on 50,000 Currency (which comes out to 2,000 Currency) and pay 2.50% of 50,000 (which comes out to 1,250 Currency), which provides us with a net income of 750 Currency!
Similarly, if we’re on the opposite side of the table (i.e. we are currently locked into a floating rate loan, and we believe that rates are going to go up), we can choose to enter into an interest rate swap agreement so that we pay fixed and receive floating.
Thus, we can use interest rate swaps to control our exposure to changes in interest rates! Whee!
Note: It should be made clear that of course there is also upside exposure if we don’t enter into an interest rate swap agreement (e.g. if we’re in a fixed rate contract, and rates go up, then we’re paying less than what the market would have us pay. If we’re in a floating rate contract, and rates go down, then we’re paying less than what we otherwise would have paid if rates did not go down).
This of course is possible! But, as in many cases pertaining to finance and accounting, we want to avoid surprises. In other words, we’d like our financial position’s sensitivity to variance in interest rates to be as low as possible.
Foreign Exchange Risk
Now that we have a nice understanding of interest rate risk, it should be much easier to generalize this concept to other forms of risk!
Foreign exchange risk is risk from to unexpected fluctuations in exchange rates. This kind of risk occurs when business is conducted across borders, and transactions may be denoted in foreign currencies.
Sidenote: There are many different kinds of exposure when it comes to foreign exchange risk, but it’s not important to go into that much detail right now. But for those who are more financially versed, we’ll only talk about foreign exchange risk in the context of transaction exposure.
Generally, only companies which operate in foreign countries (and do business denoted in foreign currencies!) will be exposed to foreign exchange risk.
Let’s say that your corporate HQ is in Canada, but you are about to launch a project in Japan. You expect income in the next couple years, but that income will be denoted in Japanese Yen (JPY). What will happen to the revenue that gets remitted to HQ if the JPY decreases in value against the Canadian Dollar (CAD)? It would make the project less profitable from the perspective of the parent company (the corporate HQ)!
For example, if you are going to receive 1,000,000 JPY every year for the next 5 years, and you are planning on converting JPY to CAD at the end of each year, then clearly your revenue will be exposed to changes in exchange rates from now until the end of the fifth year.
If the rate right now is 100 JPY/CAD, and it never changes, then at the end of each year you can expect to receive 10,000 CAD (1,000,000 / 100). But if the value of the JPY goes down and the exchange rate becomes 120 JPY/CAD (and stays that way until the last year), you’ll end up with only 8,333.33 CAD (1,000,000 / 120) per year.
Of course, like in the previous case, there’s the possibility of upside, where if the JPY appreciates against the CAD (i.e. increases in value against the CAD) you’ll end up receiving more at the end of each year. But keep in mind that we’re interested in avoiding surprises!
Hopefully by now you can see the similarities between interest rate risk and foreign exchange risk! The risk comes from uncertainty in future cash flows. Now we can come up with a swap strategy to hedge against foreign exchange risk!
Currency swaps are, at their core, very similar to interest rate swaps. Instead of doing something like “pay fixed, receive floating” (or vice versa), we can do something like “pay currency A, receive currency B”! Let’s see how we can construct such an agreement.
If we’re in the same situation as we described just now, and we want to reduce our exposure to potential future changes in the JPY/CAD exchange rate, we can choose to enter into a position with some counterparty that could look something like this:
- The currency swap will have a notional CAD amount of 10,000 CAD.
- Every year, pay the counterparty JPY equivalent to the notional amount of CAD, at the rate of 100 JPY/CAD
- Receive 10,000 CAD every year.
Note how this agreement effectively fixes the future exchange rate at which we’ll eventually exchange JPY for CAD, since we no longer have to exchange JPY for CAD at whatever the rate is at the time; we can just pay the counterparty in JPY and receive CAD.
The terms of agreement can hold additional clauses, such as “if the spot JPY/CAD rate falls outside of the range [80 JPY/CAD, 120 JPY/CAD], then the rate will move by 0.5 times the difference between the spot rate and the range boundary.” This means that if the JPY/CAD exchange rate suddenly jumps to 130 JPY/CAD, then we move our fixed 100 JPY/CAD rate by 0.5 times (130 - 120), resulting in a new rate of 105 JPY/CAD. Clauses such as this allow for a little bit of exposure to exchange rate fluctuations, which you may want if you believe that the rates will move in your favor but would still like to hedge.
Using this kind of contract, we’ve now protected ourselves against adverse changes in the exchange rate.
Some readers might note that we could just enter into a forward contract to exchange currency at a future date instead of having to go through this example of a currency swap. This is certainly true as mechanically, the contract I just described is basically the same thing as a currency forward (or several currency forwards at different time periods). The difference is that you can include terms in a currency swap: in addition to the one I described before, you could also set annual payments to an interest rate (which could be fixed or floating) on the notional amount, which sort of combines both interest rate and currency swaps!
Before describing credit default swaps (which are a slightly different flavor of swaps) we’ll need to establish a definition for credit risk.
Credit risk comes from uncertainty in a debtor’s (someone who has agreed to pay you money) ability to make payments.
Pretty vague. Whence may one derive credit risk?
- Government bonds
- Corporate bonds
- Municipal bonds
- Mortgage backed securities
These are all financial instruments that you would purchase, expecting period income. But risk arises because governments may collapse, corporations may go bankrupt, towns may fund unprofitable projects, and people may default on their mortgages, which back mortgage backed securities. If these events occur, the income guaranteed by the bond will never materialize, and we’ll end up in the red (the bond we hold will become worthless, and coupon payments will never arrive).
Credit default swaps protect us from these events!
Credit Default Swaps
Credit default swaps, much like the previous swaps that we discussed, are also a form of insurance. Instead of insuring against changes in some rate, they insure against insolvency. A credit default swap agreement looks like this:
- The credit default swap is first defined on top of an instrument that has periodic payments. Let’s say that it’s on the corporate bond issued by Good Corporation Inc.
- Agree to pay a counterparty 1,000 Currency every month for the next 5 years. But if at any point in the next 5 years, Good Corporation Inc. becomes insolvent and unable to pay the coupon payments on their corporate bond, then receive 10,000 Currency and stop paying the monthly premiums.
You could say, with tongue firmly in cheek, that credit default swaps are analogous to life insurance policies!
It should be clear now why our original definition of a swap was so vague, since it’s a very broad category of financial instrument that can help us shift risk around. We saw that we can protect ourselves against movements in the market and default (credit) risk.
If you came here interested in how you can trade these instruments, that’ll be in a different post! But it’ll definitely help to know what’s in a swap contract.
To make explanations simpler, I’ve tried to leave out many technical details on how swaps are used in practice for the purpose of getting the general idea of swaps across.
I hope I’ve managed to make swaps at least a little bit more understandable!