What Are Swaps In Stock Market & How Do They Work? | Finschool (2024)

8.1 Introduction

Swap refers to an exchange of one financial instrument for another between the parties concerned. This exchange takes place at a predetermined time, as specified in the contract. A swap in simple terms can be explained as a transaction to exchange one thing for another or 'barter'. In financial markets the two parties to a swap transaction contract to exchange cash flows. A swap is a custom tailored bilateral agreement in which cash flows are determined by applying a prearranged formula on a notional principal. Swap is an instrument used for the exchange of stream of cash flows to reduce risk.

8.2 Advantages & Disadvantages of Swaps

The advantages of swaps are as follows:

1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs.

2) Swap can be used to hedge risk, and long time period hedge is possible.

3) It provides flexible and maintains informational advantages.

4) It has longer term than futures or options. Swaps will run for years, whereas forwards and futures are for the relatively short term.

5) Using swaps can give companies a better match between their liabilities and revenues

The disadvantages of swaps are:

1) Early termination of swap before maturity may incur a breakage cost.

2) Lack of liquidity.

3) It is subject to default risk

8.3 Equity Swaps

An equity swap is an agreement between two counterparties where one party receives the return on an asset from the other party and makes a payment to the other party based on a fixed or floating rate of interest. The return can be either the price return or the total return (i.e. including dividends). Equity swaps can be combined so that one party receives the return on one asset and pays the return on another asset.

An equity swap can be used to provide long or short exposure to a stock, a stock basket, an index, or a basket of indices. One party receives the returns on the asset and the other party receives financing payments and, typically, net payments are made at periodic reset dates. Equity swaps are OTC contracts so terms can be tailored to suit the investor.

8.4 Example Of Equity Swap

Let's say an asset manager who manages a fund called Alpha Fund follows a passive investment strategy and his portfolio tracks the Nifty 50 Total Returns Index. The asset manager can enter into an equity swap contract with a counterparty say Goldman Sachs with the following terms:

Notional Principal: Rs.10crs
Alpha Fund pays: Total returns on the Nifty50 Index
Goldman Sachs pays: Fixed 5%
Payments to be made at the end of every six months, that is, 30th June and 31st December
The swap has a maturity of 3 years.

Let's see how the cash flows turn out in the first year. At the beginning, the Nifty Total Return Index was at 16000 level, on 30th June it was 16500, and on 31st December it was at 16250. Let's look at the cash flows in both the legs of the transaction.

What Are Swaps In Stock Market & How Do They Work? | Finschool (5)

Let's make a few observations from the above table:

1. If the index returns are positive, Alpha Fund pays index returns to Goldman and Goldman pays fixed rate to Alpha.
2. If the index returns are negative, Alpha pays nothing and Goldman pays the fixed rate plus any loss on the index returns. It's as if Alpha sold out its positions in stocks and had a fixed rate position instead.
3. The fixed payments are calculated on actual/365 basis.
4. The amount of payment is not known till the last day of the payment.
5. The net effect of the swap is that a position in an equity portfolio has been converted into a fixed income position.

An equity swap can be of three types: the first leg will be a fixed rate, a floating rate or an equity or index return, while the other let will always be an equity or index return. So, an equity swap can have both the legs as returns from two different equities or equity indexes.

8.5 Difference Between Swap and Futures

  • Swaps and futures are both derivatives, which are special types of financial instruments that derive their value from a number of underlying assets.
  • A swap is a contract made between two parties that agree to swap cash flows on a date set in the future.
  • A futures contract obligates a buyer to buy and a seller to sell a specific asset, at a specific price to be delivered on a predetermined date.
  • Futures contract are exchange traded and are, therefore, standardized contracts, whereas swaps generally are over the counter (OTC); they can be tailor made according to specific requirements.
  • Futures require a margin to be maintained, with the possibility of the trader being exposed to margin calls in the event that the margin falls below requirement, whereas there are no margin calls in swaps.
What Are Swaps In Stock Market & How Do They Work? | Finschool (2024)

FAQs

What Are Swaps In Stock Market & How Do They Work? | Finschool? ›

A swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.

How do swaps work in stocks? ›

A stock swap occurs when shareholders' ownership of the target company's shares is exchanged for shares of the acquiring company. During a stock swap, each company's shares must be accurately valued in order to determine a fair swap ratio between the two shares.

What is a swap in simple terms? ›

A swap is an agreement or a derivative contract between two parties for a financial exchange so that they can exchange cash flows or liabilities. Through a swap, one party promises to make a series of payments in exchange for receiving another set of payments from the second party.

What is an example of a swap in investing? ›

A swap is a derivative contract where one party exchanges or "swaps" the cash flows or value of one asset for another. For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate.

How do you make money on a swap? ›

The most popular way to profit from swap rates is the Carry Trade. You buy a currency with a high interest rate while selling a currency with a low interest rate, earning on the net interest of the difference.

How risky are swaps? ›

What are the risks. Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk. Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk.

What are the disadvantages of swaps? ›

The disadvantages of swaps are: 1) Early termination of swap before maturity may incur a breakage cost. 2) Lack of liquidity.

Why would you buy a swap? ›

The objective of a swap is to change one scheme of payments into another one of a different nature, which is more suitable to the needs or objectives of the parties, who could be retail clients, investors, or large companies.

What is the difference between swap and trade? ›

Trades are more complex than swaps, but offer more options. Swaps are designed for immediate transactions, while trades can be set for particular times, prices and market conditions.

What is a swap rate for dummies? ›

An interest rate swap is a derivative instrument (a product market value is derived or based upon other underlying value) with interest rates as underlying, 2 parties will agree under a contract to exchange of payments in fixed period based on defined notional or principal amount.

What is the most common type of swap? ›

The most common type of swap is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets.

What are the four types of swaps? ›

Types of swaps derivatives include interest rate, currency, commodity, credit default, and equity swaps, each designed to cater to different financial exposures and strategies.

What is the cost of a swap? ›

A swap is priced by solving for the par swap rate, a fixed rate that sets the present value of all future expected floating cash flows equal to the present value of all future fixed cash flows. The value of a swap at inception is zero (ignoring transaction and counterparty credit costs).

What is the fair value of a swap? ›

The swap's fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero. The notional amount of the swap matches the principal amount of the borrowing being hedged.

Is swap better than exchange? ›

The ability to quickly buy and sell an asset without having an impact on its price is referred to as liquidity. Because they frequently have a larger user base and a wider variety of trading pairs than crypto swaps, cryptocurrency exchanges frequently have higher liquidity than crypto swaps.

Is swapping better than trading? ›

Trading can be more complex and time-consuming compared to swapping. There are various trading strategies and you need to understand how the market works. Trading offers the potential for higher profits, but it also carries higher risks.

Who pays who in a swap? ›

The swap contract therefore, can be seen as a series of forward contracts. In the end there are two streams of cash flows, one from the party who is always paying a fixed interest on the notional amount, the fixed leg of the swap, the other from the party who agreed to pay the floating rate, the floating leg.

What are the advantages of a stock swap? ›

A stock swap can be a strategic move for companies looking to unlock value and achieve various objectives. One key benefit is the ability to facilitate mergers and acquisitions without the need for cash payments.

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