Swaps are essentially a series of forward rate agreements. The two parties agree to exchange payments; usually at least one party will make a payment which is dependent on a variable such as an interest rate or equity index level.
In a swap agreement the counterparties agree to exchange a sequence of cash flows over a period in the future. One party (or sometimes both parties) is usually agreeing to make payments that depend on the price of a random outcome such as the level of interest rates, currency rates or commodity prices. These payments are referred to as variable or floating. The party paying the floating rate is called the floating- or variable-rate payer, the other party the fixed-rate payer.
Each date when payments are made is called a settlement date and the time between the settlement dates is the settlement period. If payments are being made in the same currency they will be netted off against each other.
The swaps market is virtually unregulated and offers privacy for the counterparties entering into a transaction; however the parties take on the risk that the other party defaults on the transaction.
If a party wishes to terminate a swap prior to the termination or expiration date, there are a number of alternatives:
In a plain vanilla currency swap, each party holds one currency that they wish to convert to the other party’s currency. In this case the principal is swapped and then paid back at the end of the tenor of the swap. Each party will pay interest on the currency it receives from the other party.
The payments can be fixed or floating rate according to the swap agreement, but in a plain vanilla currency swap one party would pay a floating rate on dollars and the other a fixed rate on the foreign currency. Payments might be annual or for a shorter period, in which case the number of days between settlement dates is usually divided by 360, e.g. semi-annual interest is calculated using 180/360. The payments are usually made in arrears.
In a plain vanilla interest rate swap, one party agrees to pay a series of fixed-rate interest rate payments and the other party to pay a series of floating rate payments, over a period of time called the tenor of the swap. The payments are based on the interest rate calculated on a notional principal. The notional principal does not change hands.
Payments are usually determined in advance and paid in-arrears, which means that the floating rate payments are decided by the floating rate benchmark (e.g. LIBOR) at the previous settlement date. Usually only the difference between the two payments, the net payment, is made.
In this case, the variable is the return on a stock or stock index. Since the return from a stock can be negative, we could have one party paying a fixed rate plus an equity-related payment.
Another difference between equity swaps and interest rate and currency swaps is that the stock prices are only known at the end of the settlement period. Equity swaps are often structured to include both dividends and capital gains.
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