Swap Swap refers to an agreement between two parties to exchange series of payments on predetermined terms.

Swaption (Swap Option) The option to enter into an interest rate swap. In exchange for an option premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date. The agreement will specify whether the buyer of the swaption will be a fixed-rate receiver (like a call option on a bond) or a fixed-rate payer (like a put option on a bond). 1. Plain Vanilla Interest Rate Swap The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.) For example, on December 31, 2006, Company A and Company B enters into a five-year swap with the following terms: Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For

simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On December 31, 2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount. Figure 1 shows the cash flows between the parties, which occur annually

Figure 1: Cash flows for a plain vanilla interest rate swap

2. Plain Vanilla Foreign Currency Swap The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays 40 million. This satisfies each company's need for funds denominated in another currency (which is the reason for the swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1. Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year, Company C pays 40,000,000 * 3.50% = 1,400,000 to Company D. Company D will pay Company C $50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the oneyear mark, the exchange rate is $1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 - $1,960,000) to Company C.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2 Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

3. What is Commodity Swap Commodity swap refers to an agreement between two parties under which the cash flows which need to be exchanged are dependent on the price of the underlying commodity. Underlying commodity can be anything from base metal to agricultural produce, crude and other metals. Commodity swap are used by the companies in order to hedge against the rising prices of commodities, so for example if a company has steel as its raw material, but if the prices of steel are very volatile then the company can go for commodity swap where it agrees to receive payment linked to steel prices and pays a fixed rate in exchange to the other party. Commodity swap can also be used by the producer of commodity. So if producer is not sure about the revenue which he or she can get from his or her produce due to fluctuation in the commodity price then producer can go for commodity swap where the producer will agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity.

4. Equity swap An Equity Swap is a contractual agreement between two counterparties to exchange cash flows arising from specific assets over a defined period. The cash flows are exchanged periodically (i.e. monthly, quarterly) and are based upon the fixed-dollar or notional value of the swap. The notional principal of the swap is not exchanged but is used to calculate the periodic payments. In most instances, holders of concentrated equity positions would agree to pay The Bank of New York the total return (positive price performance + dividends) on the stock over a defined period based upon the notional amount of the swap. In exchange, the investor will receive the return on another asset, such as a fixed or floating money market rate, an equity index, or a basket of securities plus or minus a spread. If the return on the stock is negative, the investor will also receive the difference from The Bank of New York. Similarly, if the return on the index or basket is negative, the investor will pay the difference to The Bank of New York.

Example An investor owns 100,000 shares of ABC stock with a current market price of $75.00. The investor is unable to sell the shares due to holding period restrictions or volume limitations. The investor seeks to eliminate economic exposure to ABC stock and diversify into another asset. The investor enters into a two-year, cash-settled, equity swap with The Bank of New York whereby the investor agrees to pay at maturity the total performance of ABC stock and receives quarterly the total performance of three-month LIBOR minus a spread. The notional value of the equity swap is $7,500,000. Each quarter, The Bank of New York will pay the three-month LIBOR rate minus a spread, divided by four, multiplied by $7,500,000 to the investor. At maturity, the investor will pay to The Bank of New York the total positive price performance of ABC stock multiplied by 7,500,000 + any dividend if occurs

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the performance of either a share of stock or a stock market index. This leg is commonly referred to as the "equity leg". Most equity swaps

involve a floating leg vs. an equity leg, although some exist with two equity legs. An equity swap involves a notional principal, a specified tenor and predetermined payment intervals.

Examples Parties may agree to make periodic payments or a single payment at the maturity of the swap ("bullet" swap), the worst case. Take a simple index swap where Party A swaps 5,000,000 at LIBOR + 0.03% (also called LIBOR + 3 basis points) against 5,000,000 (FTSE to the 5,000,000 notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the 5,000,000 notional and would receive from Party B any percentage increase in the FTSE equity index applied to the 5,000,000 notional. In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days, the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*5,000,000*180/360 = 150,000 to the equity payer/floating leg receiver (Party B). At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade commencement, Party B would owe 10%*5,000,000 = 500,000 to Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement, Party A would owe an additional 10%*5,000,000 = 500,000 to Party B, since the flow is negative. 5. What is a debt/equity swap? Occasionally, a company will need to undergo some financial restructuring to better position itself for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is canceled for the newly acquired asset class.

There are many possible reasons why management would wish to restructure a company's finances. One possible reason may be that the company must meet certain contractual obligations, such as a maintaining a debt/equity ratio below a certain number or a company may issue equity to avoid making coupon and face value payments because they feel they will be unable to do so in the future. The contractual obligations mentioned can be a result of financing requirements imposed by a lending institution, such as a bank, or may be self-imposed by the company, as detailed in the company's prospectus. A company may self-impose certain valuation requirements to entice investors to purchase its stock. For illustration, assume there is an investor who owns a total of $1,500 in ZXC Corp stock. ZXC has offered all shareholders the option to swap their stock for debt at a rate of 1:1, or dollar for dollar. In this example, the investor would get $1,500 worth of debt if he or she elected to take the swap. If, on the other hand, the company really wanted investors to trade shares for bonds, it can sweeten the deal by offering a swap ratio of 1:1.5. Since investors would receive $2,250 (1.5 * $1,500) worth of debt, they essentially gained $750 for just switching asset classes. However, it is worth mentioning that the investor would lose all respective rights as a shareholder, such as voting rights, if he swapped his equity for debt.

6. Credit Default Swap CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted. The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap. Example of Credit Default Swap An investment trust owns 1 million corporation bond issued by a private housing firm. If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth 1 million.

The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of 30,000 a year for the duration of the contract. If the private housing firm doesnt default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit. If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of 1 million the value of the credit default swap. Therefore the hedge fund takes on a larger risk and could end up paying 1million The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

7. Total Return Swap A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment. Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay.

In a total return swap, the party receiving the total return will receive any income generated by the asset as well as benefit if the price of the asset appreciates over the life of the swap. In return, the total return receiver must pay the owner of the asset the set rate over the life of the swap. If the price of the assets falls over the swap's life, the total return receiver will be required to pay the asset owner the amount by which the asset has fallen in price. For example, two parties may enter into a one-year total return swap where Party A receives LIBOR + fixed margin (2%) and Party B receives the total return of the S&P 500 on a principal amount of $1 million. If LIBOR is 3.5% and the S&P 500 appreciates by 15%, Party A

will pay Party B 15% and will receive 5.5%. The payment will be netted at the end of the swap with Party B receiving a payment of $95,000 ($1 million x 15% - 5.5%). 8. Amortising swap An Amortising 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 the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.