Page 257 - A Canuck's Guide to Financial Literacy 2020

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Swaps

Swaps are financial derivative contracts that enable two parties to "swap" financial
transactions, cash flows or payments related to an underlying asset periodically or at
intervals. Many companies around the world use swaps as a way to hedge and minimize
operational risks that they may face. There are different types of swap agreements but the
most common ones that you'll run into are interest rate, currency, commodity and equity
swaps, discussed below.

The Swaps Market

Unlike options or futures, swaps do not trade on a standardized exchange but rather are
contracts negotiated between parties in the over-the-counter market. (OTC) The contracts
are "tailor-made" and details would vary based on what the parties are looking to
accomplish. Swaps specialist would fill the role of the broker and/or market maker which are
typically large institutions such as banks. Parties who enter into a swap contract do so
because they want;

• Effectively manage risk

Swaps allow parties to change the timing & profile of cash flows related to the
underlying asset.

Example: GRS Company owns 1,000,000 in fixed rate bonds earning 6% annually
which is $60,000 in cash flows per year.

GRS thinks that the interest rates will rise to 10%, which would generate $100,000
in cash flow yearly, ($40,000 more per year than the current bond holdings)

GRS approaches a swap broker with the intention of swapping cash flows.

They agree to give the swap broker $60,000 in fixed rate annual cash flows but in
return, the swap broker provides them with cash flow generated from variable rate
bonds worth $1,000,000.

The swap broker and the company would continue to exchange these cash flows
until maturity date of the contract.

• Access to new markets

Companies looking to gain exposure to certain markets may use swaps to do so. For
example, a Canadian company can opt to enter into a currency swap with a
European company in order to access more attractive CDN/EUR exchange rate
because a European based financial firm can borrow domestically at a lower rate.