Swap

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Swap</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#asset swap">asset swap</a><p class="word_list"> <a href="#liability swap">liability swap</a><p class="word_list"> <a href="#swap">swap</a><p class="word_list"> <a href="#vanilla swap">vanilla swap</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">A <b><a name="swap">swap</a></b> is a <a href="../articles/physical%20settlement.htm">cash-settled</a> <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivative</a>. Except for <a href="../articles/forward.htm">forwards</a>, swaps are the most simple form of OTC derivative. </p> <! c o p y r i g h t ( c ) C o n t i n g e n c y A n a l y s i s , 2005 > <p class="body">A swap is an agreement between two counterparties to exchange two streams of cash flows—the parties "swap" the cash flow streams. Those cash flow streams can be defined in almost any manner. All that matters is that their present values be equal (except for a bid-ask spread, if one party to the swap is a dealer). While swaps are used for various purposes—from <a href="../articles/hedging_and_diversification.htm">hedging</a> to speculation—their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability. </p> <p class="body">For example, an investor realizing <a href="../articles/return.htm">returns</a> from an <a href="../articles/common_stock.htm">equity</a> investment can swap those returns into less <a href="../articles/risk.htm">risky</a> fixed income cash flows—without having to liquidate the equities. A <a href="../articles/corporation.htm">corporation</a> with <a href="../articles/floater.htm">floating rate</a> debt can swap that debt into a fixed rate obligation—without having to retire and reissue debt.</p> <p class="body">This is illustrated in Exhibit 1. Suppose you are receiving Cash Flow Stream A from a counterparty. You would like to change the nature of that cash flow stream—perhaps making it less risky. Rather than attempt to renegotiate the obligation with the counterparty, you enter into a swap agreement with another party. Under that agreement, you swap Cash Flow Stream A for a Cash Flow Stream B, which better suits your needs.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table6"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">With a Swap, You Can Change the Character of an Asset Without Having to Liquidate the Asset.</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td> <img border="0" src="../images/ex1_swap.gif" width="350" height="250"></td> </tr> <tr> <td> <p class="exhibit_legend">By entering into a swap with a third party, you can convert a Cash Flow Stream A into a different Cash Flow Stream B. This does now require the liquidation or renegotiation of Cash Flow Stream A. Indeed, the counterparty paying you Cash Flow Stream A doesn't even need to know about the offsetting swap.</td> </tr> </table> </center> </div> <p class="body">Exhibit 1 illustrates how a swap can modify the character of an asset. If you reversed all the arrows in that exhibit, it would then illustrate how a swap can change the character of a liability.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table7"> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body">When a swap is first entered into, it has zero <a href="../articles/valuation.htm">market value</a> (except possibly for a small bid-ask spread). This is because both cash flow streams have identical, offsetting market values. As time goes by, the swap is likely to take on a positive or negative market value. This may happen for one or two reasons:</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">Market variables that affect the market values of one or both cash flow streams will fluctuate, causing the values of the cash flow streams to change. The swap's market value, which is simply the difference between the two cash flow streams' market values, will then also change.</p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">One cash flow stream may have more accelerated payments than the other, so the swap takes on a positive market value for the party making the more accelerated payments. An extreme case of this is some customized swaps that require one party to make a substantial payment right at the outset.</p> <p class="body">For the first of the above reasons, swaps entail <a href="../articles/market_risk.htm">market risk</a>. For both reasons, they entail <a href="../articles/presettlement_risk.htm">pre-settlement risk</a>. <a href="../articles/collateral.htm"> Collateralization</a> is a common way of addressing pre-settlement risk of one or both of the counterparties. <a href="../articles/settlement_risk.htm">Settlement risk</a> can be a problem for some swaps. However, cash flow streams are often structured so that payments for one occur on the same dates as payments for the other. This allows cash flows to be <a href="../articles/netting.htm">netted</a> against each other (so long as the cash flows are in the same currency).</p> <p class="body">A <b><a name="vanilla swap">vanilla swap</a></b> is any swap with fairly standardized provisions. The term is usually applied to <a href="../articles/interest_rate_swap.htm">vanilla interest rate swaps</a> or <a href="../articles/currency_swap.htm">vanilla currency swaps</a>. Vanilla swaps are appealing because pricing tends to be transparent and <a href="../articles/transaction_costs.htm">transaction costs</a> are small. Vanilla swaps can be used to speculate or to quickly hedge the market risk of a position without necessarily offsetting the specific cash flows of that position. </p> <p class="body">Swaps can also be customized to offset the specific cash flows of a position. Dealers often structure such non-vanilla swaps for clients. They may charge a fee for doing so, and pricing may reflect a large bid-ask spread (caveat emptor). An <b><a name="asset swap">asset swap</a></b> is a non-vanilla swap customized to change the character of a specific asset. A <b><a name="liability swap">liability swap</a></b> is such a swap customized to change the character of a specific liability.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td width="50%" align="left" valign="top"> <p class="body">Swaps are also categorized according to the nature of the cash flow streams being exchanged. See articles describing</p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/interest_rate_swap.htm">interest rate swaps</a></p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/currency_swap.htm">currency swaps</a></p> <p class="bullet_line_space" style="margin-bottom: 24"> <img border="0" src="../images/bullet.gif" width="20" height="10"><a href="../articles/credit_derivative.htm">total return swaps</a>.</p> <p class="bullet" style="margin-bottom: 24"> Swaps have traded since the 1980s. The first known transaction was a currency swap between the World Bank and IBM in August 1981.</p> </td> <td width="50%" align="left" valign="top"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="right" id="table9"> <tr> <td align="right" width="9"> </td> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table10"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table11"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/credit_derivative.htm">credit derivative</a> A derivative instrument designed to transfer credit risk from one party to another.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/currency_swap.htm">currency swap</a> A swap for the exchange of cash flow streams in two different currencies.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm"><strong style="font-weight: 400">derivative instrument</strong></a><strong style="font-weight: 400"> An instrument that derives value from the value of some commodity, energy, or other financial instrument.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/forward.htm">forward contract</a> A </strong>trade that is agreed to at one point in time but will take place at some later time.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/interest_rate_swap.htm">interest rate swap</a> A swap under which both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/swaption.htm">swaption</a> An option on a swap.</strong></td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; margin-bottom:2"> <a target="_top" href="http://www.riskexpertise.com/link/advertising.htm"> <font color="#000000">Ads by Contingency Analysis</font></a></p> <p style="margin-top: 0; margin-bottom: 0"> <iframe src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=iframe" style="margin: 0px; padding: 0px; border-width: 0px" width="336" height="265" frameborder="0" marginwidth="0" marginheight="0" scrolling="no" name="I1"> <![if lt IE 4]> <script src="http://servedbyadbutler.com/adserve/;ID=147917;size=336x265;setID=82436;type=js" type="text/javascript"> </script> <noscript> <a href="http://servedbyadbutler.com/go2/;ID=147917;size=336x265;setID=82436"> <img src="http://servedbyadbutler.com/adserve.ibs/;ID=147917;size=336x265;setID=82436;type=img" border="0" height="265" width="336" alt=""></a> </noscript><![endif]></iframe>   </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Books</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellpadding="6" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table12"> <tr> <td width="100%">Kolb (<a target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm">2002</a>) is a practical introduction to swaps and other derivatives. For a comprehensive treatment of swap markets, see Das (<a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm">2003</a>).<table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table13"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap367"> <area target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm" shape="rect" coords="0, 0, 92, 124"> </map> <img border="0" src="../images/book_kolb_r_(2002)_125.gif" usemap="#FPMap367" width="93" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table14"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> Futures, Options and Swaps</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Robert Kolb</b></td> </tr> <tr> <td width="10%"> <map name="FPMap75"> <area href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="1, 2, 89, 15" target="_blank"></map> <img border="0" src="../images/star_4.gif" usemap="#FPMap75" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <map name="FPMap316"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map><img border="0" src="../images/tech_2.gif" usemap="#FPMap316" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2002</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap596"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/kolb_r_(2002).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap596" width="146" height="20"></td> </tr> </table> </td> </tr> </table> <span style="font-family: Times New Roman; letter-spacing: -0.2pt"> <table border="0" cellpadding="4" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table15"> <tr> <td width="100" align="left" valign="top"> <map name="FPMap591"> <area target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm" shape="rect" coords="0, 0, 84, 124"> </map> <img border="0" src="../images/book_das_satyajit_(2003)_125.gif" usemap="#FPMap591" width="85" height="125"></td> <td align="left" valign="top"> <table border="0" cellpadding="1" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table16"> <tr> <td width="90%" colspan="3"> <p class="title"> <a target="_blank" href="http://www.riskbook.com/link/das_satyajit_(2003).htm"> Swaps/Financial Derivatives</a></td> </tr> <tr> <td colspan="3"> <p class="author"><b>Satyajit Das</b></td> </tr> <tr> <td width="10%"> <p class="author"> <map name="FPMap592"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/star_5.gif" usemap="#FPMap592" width="90" height="16"></td> <td width="10%" class="author">quality</td> <td width="70%"> <p class="author"> </td> </tr> <tr> <td width="10%"> <p class="author"> <map name="FPMap593"> <area target="_blank" href="http://www.riskbook.com/main/ratings.htm" shape="rect" coords="0, 0, 89, 15"> </map> <img border="0" src="../images/tech_2.gif" usemap="#FPMap593" width="90" height="16"></td> <td width="10%" class="author">technical</td> <td width="70%">  </td> </tr> <tr> <td width="10%"> <p class="author">2003</td> <td width="10%"> </td> <td width="70%"> <p align="center"><map name="FPMap594"> <area target="_blank" coords="0, 0, 145, 19" shape="rect" href="http://www.riskbook.com/link/das_satyajit_(2003).htm"> </map> <img border="0" src="../images/pointer_review.gif" usemap="#FPMap594" width="146" height="20"></td> </tr> </table> </td> </tr> </table> </span> </td> </tr> </table> </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table17"> <tr> <td width="100%" bgcolor="#FFFFFF"> <p align="center" style="margin-top: 18"><map name="FPMap365"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap365" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm" target="_self"> Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com"> http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com"> http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 2005<p align="center"><map name="FPMap1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1" width="241" height="89"></td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div> </body>