There are a wide variety of swaps that financial professionals trade in order to hedge against risk. Listed below are a few most common types of swap instruments traded in the market.
Interest Rate Swap
An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the conditions and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and basis for the floating index.
An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a basis swap). In brief, an interest rate swap is priced by first present valuing each leg of the swap (using the appropriate interest rate curve) and then aggregating the two results.
Credit Default Swap
A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event. A credit event is usually a default or, possibly, a credit downgrade of the entity. The reference entity may be a name, a bond, a loan, a trade receivable or some other type of liability. The buyer of a default swap pays a premium to the writer or seller in exchange for right to receive a payment should a credit event occur. In essence, the buyer is purchasing insurance.
An asset swap is a combination of a defaultable bond with a fixed-for-floating interest rate swap that swaps the coupon of the bond into the cash flows of LIBOR plus a spread. In the case of a cross currency asset swap, the principal cash flow may also be swapped. In a typical asset swap, a dealer buys a bond from a customer at the market price and sells to the customer a floating rate note at par. The dealer then enters into a fixed-for-floating swap with another counterparty to offset the floating rate obligation and the bond cash flows. For a premium bond, the dealer pays the customer the difference of the bond price and its par. For a discount bond, the customer pays the dealer the difference of the par and the bond price. In the swap with the counterparty, the dealer pays a fixed bond coupon and receives LIBOR + a spread. The spread can be determined from the cash that the dealer pays/receives and from the difference of the bond coupon and the par swap rate. When the bond redemption value is used for exchange of principal at maturity, the present value of the difference between the bond redemption value and its par value also contributes to the spread. Learn how to value an asset swap
A Trigger Swap is an interest rate swap in which payments are knocked out if the reference rate is above a given trigger rate. FINCAD provides analytics for two types of trigger swaps: periodic and permanent. For a periodic trigger swap, the exchange of payments depends on the reference rate set for that period. If the reference rate for a particular period is greater than the trigger rate, the fixed and floating payments are knocked out. If the reference rate is below the trigger rate in a subsequent period, regular fixed and floating payments are made. For a permanent trigger swap, if the fixed and floating payments are knocked out for a particular period, then all subsequent payments are knocked out as well.
A commodity swap is a swap in which one of the payment streams for a commodity is fixed and the other is floating. Usually only the payment streams, not the principal, are exchanged, although physical delivery is becoming increasingly common. Commodity swaps have been in existence since the mid-1970's and enable producers and consumers to hedge commodity prices. Usually, the consumer would be a fixed payer to hedge against rising input prices. The producer in this case pays floating (i.e., receiving fixed for the product) thereby hedging against falls in the price of the commodity. If the floating-rate price of the commodity is higher than the fixed price, the difference is paid by the floating payer, and vice versa.
Foreign-Exchange (FX) Swaps
An FX swap is where one leg's cash flows are paid in one currency, while the other leg's cash flows are paid in another currency. An FX swap can be either fixed for floating, floating for floating, or fixed for fixed. In order to price an FX swap, first each leg is present valued in its currency (using the appropriate curve for the currency).
Total Return Swap
A total return swap (TRS) is a bilateral financial contract in that one counterparty pays out the total return of a specified asset, including any interest payment and capital appreciation or depreciation, in return receives a regular fixed or floating cash flow. Typical reference assets of total return swaps are corporate bonds, loans and equities. A total return swap can be settled at the terminating date only or periodically, e.g., quarterly. For convenience we call the asset's total return a TR-leg and the fixed or floating cash flow a non-TR leg. Learn how to price a total return swap.
FINCAD products provide a number of functions for swap pricing. In addition to the types listed above, functionality is also available to price others such as BMA Basis Swaps as well as Variance and Volatility Swaps.