Importance of Swaps

Introduction

For the purpose of this essay the author will look at the concept of Swaps, explaining the applications of the basic plain vanilla swap. From there the author will delve into the origins and the history of Swaps. Then the author will provide a simple example comparing the original theory of Swaps with a simplistic modern day financial example. The author will then will examine the most common types of Swaps and finally the relevance of Swaps in order to explain the importance of Swaps in modern finance.

Concept of Swaps

Swaps are an example of a derivative. Kolb, R. & Overdahl, J. (2003) defines derivatives as

“A contract that derives most of its value from some underlying asset, reference rate, or index.”

A company will use a derivative to control the risks that will arise in its due course of the company’s normal business activities. The swap derivative is one of the most commonly used in order for the company to protect itself against risks such as currency and interest rate risk. In addition to hedging against risk exposures, a swap can also be used for speculative purposes.

Swaps are written contractual agreements between two companies where one company will exchange its stream of cash flow for the other companies’ cash flow. In standard swaps the principal amount (underlying asset) is not generally exchanged. The cash flows of each company are referred to as the legs of the swap. Generally in a swap, one leg is variable with the other leg fixed. The company which wishes to hedge its position will have a variable leg but would prefer a fixed leg. Vice versa the company which has a fixed leg would prefer a variable leg in order to speculate on changes in rate in relation to the principal amount. Generally swaps are arranged by a third party (usually a bank). The third party will take a cut on the legs being exchanged i.e. the broker may agree a fixed rate of 8% but charge 8.1% and close out this swap with another company who is looking for a floating rate and take a margin on their respective cash flow.

Origins & History of Swaps

The origins of interest swaps start with 19th century economist, David Ricardo and his “Theory of Comparative Advantage”. In his theory he uses Portugal and England as examples. His argument is that both countries could benefit from international trade with each other where Portugal made wine and cloth more productively than England. In his example he suggested that;

• if it required England 100 men to produce cloth and 120 men to produce wine

• if it took Portugal 90 men to produce cloth and 80 to produce wine

In this situation Ricardo argued that Portugal should concentrate