What Are Swaps?

If you're not awake, swaps have the potential to be a little bit confusing, so pay attention!


Generally speaking, a swap is a form of derivative that's used to help large institutions hedge risk, or reduce costs by the exchanging of cash flows in relation to certain underlying asset groups.


In this example, I'm going to write specifically about interest rate swaps, but swaps can be used for foreign exchange hedging or even speculating on the movements of prices.


How it works:

For this example we have two companies that both want to borrow £1,000,000 and a Swaps Bank:


Company 1 - Wants to borrow at a variable interest rate.

Company 2 - Wants to borrow at a fixed interest rate.


Company 1 goes to its bank, which we'll call Bank 1.

Company 2 goes to its bank, which we'll call Bank 2.


Bank 1 tells Company 1 that if it wants to borrow at a fixed rate it will have to pay 9% and if it wants to borrow at a variable rate it will have to pay the LIBOR (London Inter Bank Offer Rate).

Bank 2 tells Company 2 that if it wants to borrow at a fixed rate it will have to pay 12% and that if it wants to borrow at a variable rate it will have to pay LIBOR +1% (i.e. if LIBOR is 5% they would pay 6%, etc).


Now, the two companies could just accept the rates they're offered, but in the event that they don't want to, a swaps bank can act as an intermediary body, make some money for itself and give the banks the loans they initially wanted:


Despite wanting to pay a variable rate, let's assume that the Swaps Bank tells Company 1 to take the fixed rate of 9% on their £1,000,000 loan.

Despite wanting to pay a fixed rate, let's assume that the Swaps Bank tells Company 2 to take the variable rate of LIBOR +1% on their £1,000,000 loan.


                                       Fixed 9%                                                
                    ------------------------------------->                
   Company 1                                                 Bank 1
                    <------------------------------------                  
                                       £1,000,000                    


                                       LIBOR +1%                                                 
                    ------------------------------------->                
   Company 2                                                 Bank 2
                    <------------------------------------                  
                                       £1,000,000                  


Halfway Point Summary:


We're about halfway through the transaction and so far both companies have taken their £1,000,000 loans from their respective banks, but at the rates that they didn't want to have.

Here's where the Swaps Banks comes into play, giving them the rates they want and reducing the costs of said rates:



Continuing:


So, the Swaps Bank does a separate deal with each client (it effectively swaps over their interest rates):


The Swaps Bank tells Company 1 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 1), so they'll swap the fixed interest rate to a variable interest rate, but nothing else.

So the Swaps Bank pays Company 1 a fixed rate of 10% on a notional rate of £1,000,000 and receives LIBOR on said £1,000,000.


The Swaps Bank tells company 2 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 2), so they'll swap the variable interest rate to a fixed interest rate, but nothing else.

So the Swaps Bank pays Company 2 LIBOR on a notional rate of £1,000,000 and receives an 10.5% fixed rate on said £1,000,000.


What will happen is that every six months or so, the Swaps Bank will settle the difference for the companies between the rate they're paying the bank and the rate the bank is paying them on £1,000,000.



                                       LIBOR                                                            LIBOR
                    ------------------------------------->                  -------------------------------------->
   Company 1                                                 Swaps Bank                                                    Company 2
                    <------------------------------------                   <--------------------------------------
                                        10%                        0.5% Profit                      10.5%



How The Swaps Bank Makes Money:


The Swaps Bank makes money through taking in more from Company 2 than it's paying out to Company 1:

The Swaps Bank gets 10.5% from Company 2 and Pays 10% to Company 1, thus netting a 0.5% profit.

This may not seem like very much, but in the context of much larger sums of money over many years, these can become highly profitable transactions for the Swaps Bank.



Company Benefits:


In the case of Company 1, they could have paid LIBOR at the bank for a variable rate loan, but with this swap in place they're effectively paying LIBOR -1%, because LIBOR was paid to the Swaps Bank, but they're receiving 10% on £1,000,000 while only paying out 9% to the bank (9%-10%=-1%).


In the case of Company 2, they could have paid 12% at the bank for a variable rate loan, but with this swap in place they're effectively paying 11.5%. This is because LIBOR effectively cancels out between the Swaps Bank and Bank 2 (10.5%+1%=11.5%), making a saving of 0.5% and giving them the fixed rate they wanted.


Risks:


As with pretty much everything in finance there are risks, with the number one risk in this case being that one of the companies will go bust and thus land our Swaps Bank with an unbalanced and unprofitable deal. To hedge against this, most swaps banks will take some form of collateral from the two companies and also carry out a lot of due diligence regarding cash flows, etc.



I hope this clears up any issues with understanding interest rate swaps.

All the best,

The Masked AIM Trader