Understanding corporate finance: derivative contracts: types of derivative: other sorts of swap
Other sorts of swap
The two most widely used types of swap are interest rate and currency swaps.
Interest rate swaps
A company may swap a floating rate of interest for a fixed rate, or vice versa. For example, a company might ideally want to borrow in the fixed rate market, but finds it cannot do so at any reasonable rate. It might therefore take out a floating rate loan, and enter into a swap contract under which it pays amounts equivalent to fixed rate interest on a notional principal sum, and receives amount equivalent to floating rate interest on the same notional principal.
The net effect is the same as if it had borrowed at a fixed rate of interest.
There is more about this and other sorts of interest rate swap in the section on managing interest rate risk, CFM13280.
Historically, currency swaps were the first type of swap to be developed, but it is probably easiest to think of them as a special type of interest rate swap. They are indeed sometimes referred to as cross-currency interest rate swaps.
Under a currency swap, the parties exchange ‘interest’ payments on a principal amount denominated in one currency for ‘interest’ on a principal amount denominated in a second currency. Unlike interest rate swaps, however, the principal amounts are actually exchanged at the end of the swap period, at an exchange rate agreed in the contract.
This is dealt with in more detail, with an example, at CFM13420.
The examples at CFM13360 show swaps used to hedge credit risk. You may come across more exotic swaps which, for example, swap the rental stream from a property or portfolio of properties for an interest rate.
A swap is normally a zero cost derivative, in other words neither party has to put money up front (apart from any required payment of collateral) in order to enter into the contract. Occasionally, there may be swap arrangements where party A expects to have to pay significantly more to party B than it is likely to receive; in such circumstances B may make an up front payment to A in order to redress the balance. You may also see a termination payment going from one party to the other if a swap contract is terminated prematurely.