Financial Swaps: Get Your Head into the Cash Flow
Lesson D: Understanding How Financial Swaps Work
Although the term “swap” might seem to denote a pretty straightforward exchange of assets, in financial parlance the term is a bit different from the everyday notion of exchanging one item for another.
Financial swaps involve derivatives and therefore can become quite speculative with regard to what someone wants to hedge. Instead of swapping items or assets, swaps involve the exchange of cash flows of an asset. The easiest way to envision a cash flow is in terms of the interest rate of an asset since the interest rate determines yield of cash according to its percentage points.
In one sense, the idea of swapping cash flows is like saying,
“Well, I don’t want to or can’t sell the asset in question, so let’s see if there is someone who wants to take on part of its risk in exchange for something else.”
Let’s look at a few examples to get a better idea behind the concept of swaps. First, a non-financial example:
Insurance companies will often underwrite risks but then sell a portion of that risk to another insurance company. This is called reinsurance and it helps to spread risk and the cost of any losses incurred across two or more insurers, which helps with an insurer’s solvency.
Looking at the financial space:
Let’s say for the sake of simplicity that Alfred took out a $500,000 mortgage with a variable interest rate. When he initially took out the loan, it had an appealing 0.5% APR. He gets wind that the central bank is likely to increase interest rates over the next 6 months by 0.25% per month — meaning his APR could increase to 2% in half a year.
Alfred is worried about this potential rise. He can afford an increase up to 1.5% but anything more will make things very difficult. He is able to find a company called YouGotIt! who will “swap” the cash flow or interest rate on his mortgage. The two agree that for the next year Alfred will pay YouGotIt! 1.25% of the mortgage, while YouGotIt! Will pay anything above that rate.
Alfred is hedging his position. He knows he can pay 1.5%, but does not know if and when the interest rates will rise. By paying 1.25% for one year, he’s paying more than he would have if the interest rate does not rise and more even if the interest rate only slightly or gradually rises each month. So he’s paying more to maintain the mortgage, but at a cost he can absorb AND as an insurance net in case the rate really does rise above 1.5%.
Alfred has not only engaged in a swap, but a specific kind called a “credit default” swap.
Because swaps can be complex and involve conditions specific to a particular asset and financial climate, they are not traded on exchanges but in OTC (Over-the-Counter) markets. Swaps are traded via a broker-dealer network and typically involve small companies who often don’t meet the requirements to trade on the regular exchanges. However, institutional and retail investors can also trade in swaps under specific conditions.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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