Swaps
1) "What is a swap?"
A swap is an OTC derivative where two parties exchange cash flows based on underlying
variables like interest rates, currencies, equities, or credit risk over a fixed period,
without exchanging principal (except in currency swaps).
Swaps manage risk (hedging), reduce costs, or speculate; common types include
equity, interest rate, FX, credit default, total return, and cross-currency swaps.
2) "What is an equity swap?"
An equity swap exchanges cash flows where one leg is tied to equity returns
(stock/index price changes + dividends) and the other to fixed/floating interest.
Used to gain equity exposure without owning shares, hedge risk, cut taxes/costs, or
access restricted markets; cash-settled on notional principal.
Example: Bearish Alpha pays bullish Beta when Apple rises 5% ((105-100)/100 *
notional).
3) "What is an interest rate swap (IRS)?"
An IRS has one party pay fixed interest and receive floating (or vice versa) on a notional
principal; only net interest differentials are exchanged periodically.
Used for hedging rate risk, stabilizing cash flows, cutting borrowing costs via
comparative advantage, or speculation.
Example: Fixed payer A (5%) receives floating from B (LIBOR+2%); net settles
differences annually.
4) "What are fixed vs floating rates in IRS?"
Fixed rate: Constant payment (e.g., 5%) for stability against rises.
Floating rate: Varies with benchmarks like repo, MCLR, LIBOR/SOFR, EURIBOR, T-bills,
or MIBOR; resets periodically.
5) "What are vanilla IRS and basis swaps?"
Vanilla IRS: Fixed vs floating (e.g., 5% vs LIBOR).
Basis swap: Floating vs floating on different benchmarks (e.g., MIBOR vs repo) to
manage basis risk from imperfect correlation.
6) "What is a Total Return Swap (TRS)?"
TRS lets one party receive an asset's total return (price change + income like dividends)
while paying fixed/floating financing on notional principal.
No ownership transfer; used for leveraged exposure, hedging, speculation; features
credit risk and high leverage.
Example: Investor receives ₹12k total return but pays ₹5k financing (net +₹7k).
7) "What is a Credit Default Swap (CDS)?"
CDS is "insurance" where protection buyer pays premium to seller for coverage against
credit events (default, bankruptcy, restructuring, downgrade, etc.) on a reference
obligation.
Seller compensates buyer on trigger (e.g., pays par minus recovery); no debt ownership
transferred.
Example: Buyer pays 2% yearly on ₹10L notional until default.
8) "What is a dividend swap?"
Dividend swap exchanges fixed dividend payments for actual dividends on a
stock/portfolio over time.
Used to speculate/hedge dividend expectations without owning shares; net cash settles
differences.
Example: X pays fixed ₹5/share, receives actual (₹6, ₹4, ₹5) and nets accordingly.
9) "What is a Foreign Exchange (FX) Swap?"
FX swap has spot leg (exchange currencies today at spot rate) + forward leg (reverse at
future forward rate).
Manages short-term liquidity/currency needs without balance sheet impact.
Example: Indian bank buys USD 1M spot (INR 83M), sells forward at 83.50.
10) "What is a cross-currency swap?"
Cross-currency swap exchanges principals in two currencies at start,
swaps interest periodically (fixed/floating), and re-exchanges principals at end at
predetermined rate.
Manages currency + interest rate risk for long-term funding in foreign currency.