What is a swap?
A swap is a financial derivative in which two parties agree to exchange payments based on the movement of an underlying asset.In a fixed rate for a floating rate swap, one party pays a fixed rate and receives a floating rate, while the counterparty pays a fixed rate and receives a floating rate.Each party believes interest rates are heading in different directions and is attempting to achieve a more favourable outcome using rate fluctuations synthetically.A derivatives transaction is a zero-sum game: one party wins, and one party loses. Based on the frequency of payment, net payment will be made each period from the party that is losing to the winning party.
Example of swap:
For example, consider a 3-month OIS with a notional principal of \$25 million and an OIS rate (fixed rate) of 2.5%. If the geometric average of the overnight rates during the three months is 2.7%, the floating side has to make a payment to the fixed rate payer of \$12,500, calculated as 3 / 12 × (0.027 – 0.025) × \$25 million
Also, To illustrate how a swap may work, let’s look further into an example. ABC Company and XYZ Company enter into a one-year interest rate swap with a nominal value of \$1 million. ABC offers XYZ a fixed annual rate of 5% in exchange for a rate of LIBOR plus 1% since both parties believe that LIBOR will be roughly 4%. At the end of the year, ABC will pay XYZ \$50,000 (5% of \$1 million). If the LIBOR rate is trading at 4.75%, XYZ will have to pay ABC Company \$57,500 (5.75% of \$1 million because of the agreement to pay LIBOR plus 1%).
Therefore, the value of the swap to ABC and XYZ is the difference between what they receive and spend. Since LIBOR ended up higher than both companies thought, ABC won out with a gain of \$7,500, while XYZ realised a loss of \$7,500. Generally, only the net payment will be made. When XYZ pays \$7,500 to ABC, both companies avoid the cost and complexities of each company paying the entire \$50,000 and \$57,500.
When are swaps necessary?
Swaps are beneficial when one company wants to receive a payment with a variable interest rate whilst the other wants to limit future risk by receiving a fixed-rate payment.