What it means
A swap is an agreement between two parties to exchange cash flows over a period of time. A company that has a floating-rate loan and wants predictable payments might swap into a fixed rate, while another company with the opposite need might swap the other way.
Finding each other directly is hard, so a swap bank steps in. The bank has two main ways of working.
It can act as a broker, introducing the two parties and taking a fee, or it can act as a dealer, entering into a swap with each party separately and keeping a spread. In the dealer model, the bank takes on the risk that one of the parties will fail to pay, and often manages its exposure by trading with other institutions.
For companies, using a swap bank brings flexibility and cost savings. A business can fix the interest on a loan, convert a loan from one currency to another or manage exposure to commodity prices.
The service is usually provided by large banks that have the credit strength, systems and trading skills to manage the risks involved. The swap bank must pay close attention to credit risk and market risk.
It must be sure that each party can meet its obligations, and it often takes collateral, which is assets pledged as security. It also has to measure how the value of its swap portfolio moves when interest rates or exchange rates change.
The nuance is that the swap bank is not a neutral party in the dealer model. Its profit comes from the spread built into the prices it quotes, so companies benefit from asking for quotes from more than one bank.
Regulation of swap markets has also increased, with more reporting and clearing requirements in many countries.
In practice
Real-world examples.
Example
A manufacturing company has a $25 million floating-rate loan and worries that interest rates will rise. It asks its bank to arrange a swap so that it pays a fixed rate and receives the floating rate, which covers the loan payments.
Example
A multinational borrows in dollars but earns revenue in euros. A swap bank arranges a currency swap that converts the dollar payments into euro payments, reducing the risk of a mismatch between income and debt.
Example
A regional utility and an insurance company have opposite views on rates. A swap bank matches them, with the utility paying fixed and the insurer paying floating, and earns a small spread for taking on the credit risk of both.
Formula
Calculation
Swap bank's annual spread income = notional amount x (fixed rate received - fixed rate paid)
Suppose Company A wants to pay a fixed rate and receive a floating rate, and Company B wants the opposite. The notional amount, which is the figure on which payments are calculated, is $10,000,000. The bank receives a fixed 5.10% from Company A and pays a fixed 4.90% to Company B, passing the floating payments through unchanged. The spread is 5.10% - 4.90% = 0.20%. The bank earns 10,000,000 x 0.0020 = $20,000 a year for arranging the swap and bearing the credit risk of both parties.Case study
Seen in the real world.
Linden and Voss Bank is an illustrative, fictional institution that runs a swap desk serving mid-sized companies. A client, Crestline Foods, had a $40 million floating-rate loan and wanted certainty over its interest costs for five years.
The desk quoted a fixed rate of 4.75% against receiving the floating rate. On its own books, the desk laid off the risk by entering an opposite swap at 4.60%, earning a spread of 0.15% on $40 million, which is $60,000 a year.
Crestline's treasurer compared the quote with a second bank and negotiated it down to 4.70%. In this illustrative case, the swap bank still made a profit of $40,000 a year, while the client gained a predictable cost of borrowing.
Watch out
Common mistakes.
- Assuming a swap bank is a neutral matchmaker, when in the dealer model it earns a spread and takes credit risk.
- Accepting the first quote without comparing other banks, which can mean paying more than necessary.
- Ignoring counterparty risk, since a swap's value depends on the other party being able to pay.
Questions
People also ask.
What does a swap bank do?
It arranges or takes part in swaps so that two parties can exchange payment streams, such as fixed and floating interest, and it earns a fee or spread.
Is a swap bank a special kind of bank?
Not usually, as it is generally a large commercial or investment bank with a swap desk rather than a separate type of institution.
What is a notional amount?
It is the reference amount on which swap payments are calculated, and it is normally not exchanged between the parties.
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