Swaps

A swap is a type of contract which facilitates the hedging of risk. The swap contract is an agreement between two parties to exchange ("swap") a series of cash flows at specific intervals over a specific period of time. The swap payments are based on an agreed principal amount (the notional amount). There is no immediate payment of money to either party as compensation for getting into the contract. Therefore, the swap contract itself provides absolutely no new funds to either party.

In principle, a swap contract could call for the exchange with anything. In current practice, however, the majority of swap contracts involve the exchange of commodities, currencies or even securities' returns.

Let's look at how a foreign currency swap works and just how it can be used to hedge risk. Suppose that you own a software company in the United States, and a German company wants to buy the rights to purchase as well as market your software program in Germany. The German company agrees to pay your company 100,000 marks (DM100,000) each year for the next ten years for these rights.

If you want to hedge the risk of fluctuations within the dollar value of the expected stream of revenues (due to fluctuations in the dollar/mark exchange rate), you are able to enter a foreign currency swap now to exchange your future flow of German marks for a future stream of U.S. dollars at a forward exchange rates specified now.

The swap contract is therefore equivalent to a number of forward contracts. The actual notional amount within the swap contract corresponds to the face value of the implied forward contract.

To demonstrate with numbers, suppose that the dollar/mark exchange rate is currently $.50 per mark and that exchange price also applies to all forward contracts in the next ten years. The notional amount in your swap contract is 100,000 marks per year. By getting into the swap agreement, you lock in the dollar revenue of $50,000 each year (DM100,000 x $.50 for each DM). Each year on the settlement date, you are going to receive (or pay) an amount of cash corresponding to 100,000 marks times the difference between the forward rate and the actual spot price at that time.

Thus, suppose that one year from now on the settlement date the spot rate of exchange is $.40 per mark. The party on the other side of the swap contract, the counterparty (the German company in our example), is obligated to pay you 100,000 times the difference between $.50 for each mark forward rate and the $.40 per mark spot rate, i.e., $10,000.

With no swap contract, your revenues from the software license agreement will be $40,000 (100,000 times the spot rate of $.40 per mark). But with the swap contract, your total revenues will be $50,000; you receive DM100,000 from the German company, which you sell to get $40,000 and you receive an additional $10,000 from the counterparty to your swap contract.

Now suppose that in the second year on the settlement day, the spot rate of exchange is $.70 per mark. You will be obligated to pay the counterparty to your swap agreement 100,000 times the difference between the $.70 per mark spot rate and the $.50 per mark forward rate, i.e., $20,000. Without the swap agreement, your cash revenues from the software license contract would be $70,000 (100,000 times the spot rate of $.70 for each mark). But with the actual swap contract, your total revenues is going to be $50,000. Therefore, in the second year, you will probably wish that you did not have the swap contract. But the potential of having to give up gains in order to eliminate possible losses is the essence of hedging.

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