What is a Swaption?

Swap, words mean interchange. Financial transactions in which two or more parties in a swap regularly exchange cash flows within agreed time within agreed terms can be divided into categories such as currency swaps, interest rate swaps, equity swaps, and credit swaps.

[hù huàn]

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Chinese name: exchange
Overview: Meaning of words
Pinyin: hù huàn

Swap words: Exchange similar things with each other ...
Swap transaction: Participants and motivations:
References: Golden Dictionary of Finance

Pinyin: hù huàn

Basic meaning

verb

[exchange]

Introduction to Swap

Swap is a derivative that allows two or more parties to exchange a series of cash flows in accordance with the terms of the agreement and within the agreed time. The return depends on the type of financial instrument involved. For example, in the case of the exchange of two bonds, the return is the regular interest (or coupon) related to the bond. Specifically, the two opponents agreed to exchange each other's cash flow. These cash flows are also called "legs". The swap agreement stipulates the date on which the cash flow is paid and how it is calculated

exchange transaction. ^[1] The origin of this transaction is back-to-back loans. For example, a French company loaned a French franc to a US company for a 5-year loan at an interest rate of 10%, and the American company in turn lent an equivalent amount of 5 years to the French company The US dollar loan has an interest rate of 8%. Through this process, the two companies exchange principal and interest payments, which is equivalent to a French company exchanging a certain amount of francs for a certain amount of dollars at a fixed exchange rate. In essence, this is a forward foreign exchange transaction. This back-to-back loan was popular in the 1970s. In 1981, currency swaps appeared, followed by swaps with a mix of interest rate swaps and currency interest rates.

Swap type

1. Interest rate swap: It means that the two parties agree to exchange cash flows based on the same nominal principal of the same currency within a certain period in the future.

2. Currency swap: Refers to the exchange of the principal and fixed interest of one currency with the equivalent principal and fixed interest of another currency.

3 Commodity swap: It is a special type of financial transaction. In order to manage commodity price risk, both parties to the transaction agree to exchange cash flows related to commodity prices. It includes fixed price and floating price commodity price swaps and swaps of commodity prices and interest rates.

4 Other swaps: equity swaps, credit swaps, climate swaps and swap options.

Swap participants and motivations

Swap participants

(A) the government

The government uses the swap market to carry out interest rate risk management business, and adjusts the proportion of fixed and floating interest rate debt in its asset portfolio. Most governments with deficits have most of their debt financing at fixed interest rates, and some international sovereign bonds are floating

exchange Interest rate notes. Many governments in Europe and beyond use the swap market to swap fixed-rate bond issuance from one currency to another or to get cheaper floating-rate funds from it.

(II) Government agencies and municipal governments

Many government agencies, state-owned enterprises, cities and municipalities use swap markets to reduce financing costs, or borrow in markets where investors have a strong demand for their bonds and the borrowers themselves do not need that currency. Borrowers can use the swap market to separate financing decisions from currency risk management decisions. Foreign currency borrowing may create the possibility that the total cost of debt is higher or lower than interest rates, because changes in the value of the borrowed currency will change financing costs.

(3) Export credit agencies

Export credit agencies provide price-competitive financing to expand the country's exports. Export credit agencies use swaps to reduce borrowing costs and diversify funding sources. The costs saved through the credit arbitrage process are shared among local borrowers, which form the customer base of export credit agencies. Some export credit agencies, especially from the Nordic countries, have been active borrowers in the international bond market. Some have successfully created financing projects to be able to borrow at preferential interest rates. The swap market enables them to decentralize financing channels, make borrowing currencies wider, and then swap back the currencies they need. Swap also enables borrowers to manage interest rates and currency risks.

(D) supranational institutions

A supranational institution is a legal person jointly owned by more than one government. Due to the government's financial support, the balance sheet is usually good. Some supernational institutions are considered by some institutional investors as one of the best credit in the capital market. Supernational institutions usually borrow on behalf of customers because they can raise funds at very favorable prices and share the savings with customers.

(5) Financial institutions

A wide range of financial institutions use swap markets, including deposit and loan associations, building and construction associations, insurance companies, pension funds, hedge funds, central banks, savings banks, commercial banks, merchant banks, investment banks and securities companies, and commercial banks and Investment banks are active in the swap market. They not only trade for their own accounts, but also trade on behalf of their customers. Banks use swaps as trading tools, hedging technologies and market making tools.

(VI) Company

Many large companies are active in the swap market. They use swaps to hedge interest rate risk and pair assets with liabilities in much the same way as banks. Some companies use swap markets to exchange their views on interest rates and explore opportunities for credit arbitrage.

There are other participants in the swap market, including various trading associations, brokers, system sellers, and publishers.

Swap motivation

The fundamental reason for the swap is that there are comparative advantages on both sides of the swap

Pros and cons

Swap has its own advantages over other derivatives

1. Swap transactions combine foreign exchange market, securities market, short-term money market, and long-term capital market business. They are both innovative financing tools and can be used for financial management.

2. The swap can meet the requirements of traders for non-standardized transactions and has a wide range of applications.

3. The use of swap hedging can save the day-to-day management of positions required by other financial derivatives, and it is easy to use and the risk transfer is fast.

4. The duration of the swap transaction is flexible, the length of which is arbitrary, and the longest period can be up to several decades.

5. The creation of swap warehouses makes banks the subject of swaps, so the swap market is highly liquid.

Disadvantages in swap transactions

There are many risks in the swap transaction itself. Credit risk is faced by swap exchanges

exchange The main risk is also the risk that the swap party and the intermediary agency may fail to perform the contract due to various reasons such as default and non-payment. In addition, because the swap period is usually as long as several years, there is still the risk of swap interest rates for buyers and sellers.

Risks of swap transactions

Bearer of swap transaction risk

The bearers of swap transaction risks include:

Both parties to the contract. In the swap transaction, they have to bear the original debt or the new debt, and actually carry out the debt exchange.

Intermediary banks. It plays an intermediary role in the receipt and payment of funds by both parties to the contract.

Dealer. His responsibility is to arrange the overall rules of the swap transaction, determine the swap conditions satisfactory to the parties, and mediate various disputes. It is not itself a party to the contract. It is generally held by an investment bank, a merchant bank, or a securities company. It charges a (one-time) certain swap arrangement fee, usually 0.125% to 0.375% of the total.