Swaps versus futures

· Swaps can be customized and do not require any margin payments, but they do create a lot of credit risk.
· Futures are more liquid and so cheaper. They do require margin but do not create any credit risk.
· Swaps are mainly used by large firms and institutional investors for hedging. Futures are used for both hedging and speculation by individuals as well as institutional investors.

Advantages and Limitations of swaps over capital markets

Advanateges:
· Low financing cost due to lower transaction costs
· Quick and anonymous execution in OTC markets with no regulations, and anonymity.
· Allow to hedge over longer time horizons.
· Allow custom designed contract (historically , exploit perceived market inefficient is not possible today as the market is getting matured and offered few arbitrage apportunities)
· Comparative advantage

Limitations:
· difficult to find counterparties
· difficult tohttp://cfa-studynotes.blogspot.com/2009/01/characteristics-of-swaps.html alter or terminate once initiated
· other counterparties exposes to default risk (most important among the limitations)
· Swaps usually limited to small no of firms , financial institutions, swap facilitator.

Interest Rate Swap (plain vanilla) and Currency Swap

Interest rate swap (plain vanilla):
· One party pays interest coupons based on a fixed rate and the other pays coupons based on LIBOR that sets for the period.
· Payments are exchanged on a net basis and there is no exchange of notional value.
· At least one of the sequence of cash flow is uncertain.

Currency swap:

· Notional amounts and payments on the two sides are denominated in different currencies. The most common type involves the exchange of LIBOR-based payments in US dollars and fixed rate payments in a foreign currency
· A borrower who has floating rate liabilities and is concerned about a rise in interest rates should enter into a pay-fixed swap to fix its cost of debt.A borrower who has fixed rate liabilities and is concerned about a fall in interest rates should enter into a receive-fixed swap to convert its debt into floating rate.
· The notional principal change hands at the beginning of the swap; Interest payment are made without netting (A pays interest in USD to B, D pays in AUD to B at the settlement date)
· The notional principal is swapped again at the termination of the agreement;
· Generally, the variable interest rate for USD determined at the beginning and pay at the end of the settlement period.

Terminating a Swap Contract

The easiest way to terminate the contract is to hold it to maturity. However, if one or both parties in a swap contract wish to terminate, there are several methods:
· Enter into a separate and offsetting swap
· Cash settlement based on market value.
· Sell the swap to another party, usually requires permission from the other party and not commonly used in the market place.
· Use a swaption. A swaption gives the owner the right to enter into another swap at terms that are set in advance. By executing the swaption, the party can offset its current swap.

Characteristics of Swaps

· Non-standardized contracts that are traded over the counter (OTC), allow to deal with much longer horizons than exchange-traded instruments, but subject to credit risk
· give greater privacy & escape regulation.
· Swaps are contracts that exchange assets, liabilities, currencies, securities, equity participations and commodities.
· Generally used for risk management by institutions
· Most involve multiple payments as a series of forward contracts, although one-payment contracts are possible
· When initiated, neither party exchanges any cash, a swap has zero value at the beginning.