Definition and Examples of Swap Transactions
A swap is a contract between investors that involves the “exchange” or swapping of cash flows. For example, one party will receive a fixed interest rate and pay the other party a variable rate. These cash flows are derived from certain underlying assets, but these assets do not change ownership.
How Do Swaps Work?
Companies use swaps to hedge risks related to financial choices, such as issuing bonds or stocks. If a company wants to issue bonds but is uncomfortable with the interest payments it will have to make to bondholders, it might look for another company to exchange with.
For instance, suppose Company X wants to issue bonds at a variable rate but is worried about rising rates. In this case, it might seek another company that agrees to pay the bond interest on its behalf.
If Company Y agrees to pay the interest on behalf of Company X, Company Y may request a fixed interest payment on a specific amount of money. If rates rise, Company X will benefit more, as it may end up paying lower interest to Company Y. If rates decrease, Company Y may benefit more, as it will receive more from Company X.
Note: Often, one side of the swap agreement is fixed, while the other side is variable.
A swap can involve multiple financial exchanges during the contract period, which can last as long as the parties wish. There are times when one party wants to terminate the swap before its maturity. In this case, both traders can agree on the amount due, or reach a cash equivalent of the contract, or even create a new contract position. Before 2010, swap contracts were not traded on public exchanges and were unregulated. Parties were free to create contracts as they saw fit.
On July 21, 2010, Congress passed the Dodd-Frank Act for reforming and protecting Wall Street, which granted the Securities and Exchange Commission and the Commodity Futures Trading Commission the authority to regulate swaps, which grew to become a trillion-dollar market.
What Do Swaps Mean for Investors?
Swap contracts are often entered into by major financial institutions and banks. Therefore, investors dealing in swaps must have significant capital and be able to fulfill the agreed payments.
Exchange-Traded Funds (ETFs) are one of the newest types of investments available. The first ETF appeared in the American market in 1993 and continues to trade today. Swaps have been integrated with ETFs to make them available to the general investor.
Swap-Linked ETFs
In October 2020, the Securities and Exchange Commission voted to allow investment firms to include derivatives in their funds, enabling companies like mutual funds and ETFs to contain swaps in their portfolios.
Note: Swap-linked ETFs must adhere to certain standards, such as having a risk management program, limits on risks associated with leverage, and maintaining specific records to protect investors.
Individual investors looking for ways to invest in swaps can find swap-linked ETFs, also known as “synthetic ETFs.” Derivatives and swaps are used in these funds to help keep the fund aligned with the index that the ETF follows.
These funds do not own any of the underlying assets but can be funded or unfunded. A funded synthetic ETF provides pooled assets to the counterparty. In return, the counterparty pays the returns. An unfunded synthetic ETF tracks an index but may not hold any of the securities in the index.
It pays
The synthetic uncollateralized ETF swaps the returns from securities in the other party’s ETF. The other party then pays the returns from the securities in the index.
Swap Transaction Risks
The passage of the Dodd-Frank Act to reform and protect Wall Street has reduced the high risks previously associated with the unregulated swap market. Swaps can be a reliable investment venue for those who can bear the cost, as high-value companies are the ones that typically initiate them. However, risks still exist.
Individuals face risks that go beyond the market risk of the underlying investments. Counterparty risk includes the risk of the other party not fulfilling their obligations. A conflict of interest may arise if the parties involved in a swap take on more than one role in the fund or swap. The danger comes from one party having a significant investment in the swap.
If guarantees are given, risks materialize in the form of decreased value or ineffectiveness related to the ETF’s goal. If the ETF linked to swaps is concentrated in a specific market sector, investors face concentration risk.
Conclusion
Swaps are contracts between investors to exchange cash flows, payments, or obligations on assets. Swaps can be derived from equities, bonds, commodities, foreign currencies, or any other investment instrument. Swaps are not traded on exchanges but are conducted over the counter between private parties. Regular investors do not have access to swaps unless they are part of an ETF or another type of fund.
Source: https://www.thebalancemoney.com/what-are-swap-contracts-1214894
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