Of the four most common derivatives, the swap is easily the most confusing. Why? Because each swap involves two agreements rather than just one. Swaps occur when corporations agree to exchange something of value with the expectation of exchanging back at some future date.
Corporations can apply swaps to a number of different things of value, usually currency or specific types of cash flows. Simply speaking, they allow corporations to benefit from transactions that otherwise would not be possible to them in a timely or cost-effective manner.
Because swaps give corporations the opportunity to shift the performance of their assets quickly and cheaply without actually exchanging ownership of those assets, they’ve become extremely popular as a method of managing risk and generating revenues. Swaps are typically done through a swap broker, a company that deals in swaps and makes money off the bid-ask spread (the difference between the bid price and ask price) on these exchanges.
Risk management and swap derivatives
Swaps are used to manage risk in a couple ways. First, you can use swaps to ensure favorable cash flows, either through timing (as with the coupons on bonds) or through the types of assets being exchanged (as with foreign exchange swaps that ensure a corporation has the right type of currency). The exact nature of the risk being managed depends on the type of swap being used.
The easiest way to see how companies can use swaps to manage risks is to follow a simple example using interest-rate swaps, the most common form of swaps.
Company A owns $1,000,000 in fixed rate bonds earning 5 percent annually, which is $50,000 in cash flows each year.
Company A thinks interest rates will rise to 10 percent, which will yield $100,000 in annual cash flows ($50,000 more per year than their current bond holdings), but exchanging all $1,000,000 for bonds that will yield the higher rate would be too costly.
Company A goes to a swap broker and exchanges not the bonds themselves but the company’s right to the future cash flows.
Company A agrees to give the swap broker the $50,000 in fixed rate annual cash flows, and in return, the swap broker gives the company the cash flows from variable rate bonds worth $1,000,000.
Company A and the swap broker continue to exchange these cash flows over the life of the swap, which ends on a date determined at the time the contract is signed.
In this example, swaps help Company A manage its risk by making available to Company A the possibility of altering its investment portfolio without the costly, difficult, and sometimes impossible process of actually rearranging asset ownership.
As a result, Company A makes an additional $50,000 per year in bond returns. Of course, like with many investments, the company could also lose money if interest rates were to decrease rather than increase as Company A projected.
Each side typically benefits from swaps, and it’s the job of the swap broker to help different corporations that would benefit from swapping together to find each other. The swap broker earns money by charging a fee.
Revenue generation and swap derivatives
When pursuing opportunities to generate revenue through swaps, the process is no different, but the motivation behind the swap is to take advantage of differentials in the spot and anticipated future values related to the swap. To see how revenue generation works with swaps, consider the following example, which involves foreign exchange swaps, a simpler but less common form of swap (in the example, USD = U.S. dollar):
Company A has USD 1,000 and believes that the Chinese Yuan (CNY) is set to increase in value compared to the USD.
Company A gets in touch with Company B in China, which just happens to need USD for a short time to fund a capital investment in computers coming from the U.S.
The two companies agree to swap currency at the current market exchange rate, which for this example, is USD 1 = CNY 1.
They swap USD 1,000 for CNY 1,000. The swap agreement states that they’ll exchange currencies back in one year at the forward rate (also USD 1 = CNY 1; it’s a very stable market in Example-World).
In the example, Company B needs the currency but doesn’t want to pay the transaction fees, while Company A is speculating on the change in exchange rate. If the CNY were to increase by 1 percent compared to the USD, then Company A would make a profit on the swap.
If the CNY were to decrease in value by 1 percent, then Company A would lose money on the swap. This potential for loss is why using derivatives to generate income is called speculating. (Did you know the term speculate means “to come by way of very loose interpretation” or “to guess”?)
Valuation of swap derivatives
The value of a swap isn’t very difficult to measure. Simply put, you start with the value of what you’re receiving plus any added value that results from changes in rates or returns and then subtract the value of what you’re giving away plus any increases in value associated with interest earned or changes in rates.
Of course, as with all known valuations, this is a hindsight calculation. When you’re estimating future value, the calculations involve the time value of money and the probabilities of event occurrences, both of which should be treated in the same manner as estimating the value of futures. Remember that a swap is nothing more than a combination of a spot rate exchange and a futures exchange in a single contract.