Swap Risks

What are Swap Risks？

A swap is a type of derivative contract via which two counterparties exchange the cash flows or liabilities from two different financial instruments.

There are many types of swaps, including interest rate swaps, currency swaps, commodity swaps, credit default swaps, equity swaps, and total return swaps. Of the cash flows exchanged in a swap contract, one is of fixed value while the other involves floating payments based on an interest rate, floating exchange rate, or index price. The two most common types of swap transactions are interest rate swaps and currency swaps.

Counterparties enter into swap agreements to exchange one stream of payments for another that is more suited to their objectives. Swaps are often used to hedge against risk. It is important that investors understand the market before engaging in swap transactions.

Swap Risks

There are two main forms of risk involved in swap contracts: price risk and counterparty risk.

1)     Price risk: This risk arises due to the movement of the underlying rate or index so that the default-free present value of the future payment stream changes. For example, in the most common interest rate swaps, both parties to the contract may face interest rate risk due to unpredictable interest rate fluctuations. The counterparty receiving payments based on a fixed rate is exposed to the risk of a rise in the floating rate, which means that they would forgo a payment stream based on a higher interest rate. Conversely, the recipient of payments based on a floating rate is exposed to the risk that the interest rate will fall and they will be required to continue paying at the higher fixed rate.

2)     Counterparty risk: This refers to the potential for losses that would arise from one counterparty defaulting on their obligation. For instance, if the floating rate is higher than the fixed-rate, the party paying the floating rate will need to pay the receiving party based on the difference between the two rates. If the floating rate payer defaults, this will result in a loss to the floating rate receiver. In the longer run, where there is increased risk, swaps can be cost-effective compared with other types of derivatives.

How to Reduce Swap Risks?

1)     The price risk of swap contracts can be hedged through swaptions, interest rate futures, currency futures, and other related derivative instruments.

2)     One of the most effective ways to reduce counterparty risk is to trade only with high-quality counterparties with high credit ratings.

3)     Collateralization is another useful tool to reduce counterparty risk and involves placing high-quality collateral such as cash or liquid securities.

4)     Risk can also be reduced by trading with multiple counterparties to ensure that risk is not concentrated in a single counterparty.

Example

Firm X and Firm Y enter into a one-year interest rate swap with a notional value of $50 million. Firm X offers Firm Y a fixed annual interest rate of 6% in exchange for a floating rate of LIBOR plus 1.5%; both parties predict that LIBOR will be about 4.5%.

At the end of the year, fixed-rate payer Firm X will pay Firm Y $3,000,000 (6% of $50 million). If the LIBOR rate is 5%, floating-rate payer Firm Y will pay Firm X $3,250,000 (6.5% of $50 million). If Firm Y defaults, this will result in a loss to Firm X, and Firm X accordingly needs to keep a certain amount of capital as provision for a default arising from the counterparty risk.

Conclusion

A swap is a financial contract between two parties in which each party makes periodic payments to the other based on an underlying rate or index according to pre-specified rules. Swaps essentially allow the counterparties to buy and sell risk. Investors must carefully understand the market and risks before using swaps to hedge risks or profit from speculation in swaps. The primary risks associated with swap contracts are price risk due to changes in the underlying rate or index and counterparty risk based on the potential default of one counterparty.

Swap risks can be mitigated by hedging with related derivatives, trading with multiple, high-quality counterparties, and using collateral such as cash or liquid securities.

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