Other Types of Swaps

Following are some other types of swaps:

Other Types of Swaps

1. Basis Rate Swaps: It is a type of swap in which two parties swap variable interest rates based on different money markets.

This is usually done to limit the interest-rate risk that a company faces as a result of having differing lending and borrowing rates.

2. Differential Swaps: A differential swap is an interest rate swap based on the interest rates in two countries but where the payments are made in a single currency.

For example, a U.S. firm might be concerned that German interest rates will increase relative to U.S. rates.

It could hedge this position by purchasing a euro-denominated floating-rate note and selling a dollar-denominated floating-rate note.

This would, however, be assuming unwanted currency risk.

Alternatively, it could enter into a diff swap in which it receives the German interest rate and pays the U.S. interest rate, with all payments made in dollars.

Thus, if German interest rates rise relative to U.S. interest rates, the swap will result in a net payment in dollars to the firm.

Obviously, the dealer in such a swap would incur the currency risk and would probably pass on to the party, the cost of hedging that risk, but presumably, the dealer could do it much cheaper.

It should be apparent that this swap is simply a currency-hedged basis swap.

If the interest rates of one country are consistently higher than those in the other country, there would be a spread similar to that in a basis swap negotiated upfront.

3. Credit Default Swaps: A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a pay-off if a credit instrument, typically a bond or loan, goes into default (fails to pay).

Less commonly, the credit event that triggers the pay-off can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded.

CDS contracts have been compared with insurance because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs.

4. Other Variations: There are different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures. These variations are as follows:

i. Total Return Swap: A total return swap is a swap in which Party A pays the total return of an asset, and party B makes periodic interest payments.

The total return is the capital gain or loss, plus any interest or dividend payments. If the total return is negative, then party A receives this amount from party B.

The parties have exposure to the return of the underlying stock or index without having to hold the underlying assets.

The profit or loss of party B is the same for him as actually owning the underlying asset.

ii. Swaption: An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap.

iii. Variance Swap: A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, i.e., volatility, of some underlying product, like an exchange rate, interest rate, or stock index.

iv. Constant Maturity Swap: A Constant Maturity Swap, also known as a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.

v. Amortizing Swap: An amortizing swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as LIBOR.

vi. Rate Anticipation Swap: A type of swap in which bonds are swapped according to their current duration and predicted interest rate movements.

Investors will usually participate in these swaps to maximize profits from favorable interest rate movements and minimize losses from unfavorable movements.

For example, bonds with higher duration generally exhibit higher price fluctuations when an interest rate changes.

If interest rates are expected to decline, investors will swap for bonds with a higher duration in order to maximize potential gains from the price movement.

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