Interest Rate Swaps - Fundamentals › Other Common Swap Types

While plain-vanilla interest rate swaps dominate the market, several other swap structures serve specialized needs.

Currency swaps extend the swap concept to exchange cash flows in different currencies. Unlike interest rate swaps where notional principal is never exchanged, currency swaps typically involve exchanging principal at both the start and end of the contract.

Consider a U.S. company that needs euros for a European subsidiary. Rather than borrowing directly in euros (where it may have limited access or higher costs), the company can borrow in dollars and enter a currency swap. At inception, it pays dollars and receives euros. Throughout the life of the swap, it pays euro interest and receives dollar interest. At maturity, the principal amounts are re-exchanged at the original exchange rate.

Currency swaps serve several purposes:

• Funding foreign operations: Companies can access foreign currency funding indirectly.
• Hedging foreign currency debt: A company with euro-denominated debt can hedge its exposure back to dollars.
• Exploiting funding advantages: Like interest rate swaps, currency swaps can exploit comparative advantages across different currency markets.

Commodity swaps allow parties to exchange fixed payments for floating payments tied to commodity prices. An airline might enter a swap where it pays a fixed price per barrel of jet fuel and receives floating payments based on the actual market price. This hedges the airline's fuel cost exposure by converting uncertain future costs into known, budgetable amounts.

The structure mirrors interest rate swaps, with the commodity price replacing the interest rate in the calculation. The net payment for each settlement period is determined by comparing the agreed fixed price to the observed market price:

$$\text{Net Payment} = \text{Notional Quantity} \times (\text{Fixed Price} - \text{Floating Price})$$

where:

• Notional Quantity: the volume of the commodity (e.g., barrels of oil)
• Fixed Price: the price per unit agreed upon at contract inception
• Floating Price: the market price per unit observed at the reset date

The formula shows that when the floating market price exceeds the fixed price, the net payment is negative for the fixed-price payer, meaning they receive a payment that offsets their higher actual purchasing costs. Conversely, when market prices fall below the fixed price, the fixed-price payer makes a net payment but benefits from lower actual purchase costs. The swap effectively locks in the fixed price regardless of market movements.

For a commodity consumer (like an airline), paying fixed and receiving floating locks in costs. For a producer (like an oil company), the opposite position locks in revenues.

A basis swap exchanges two different floating rates rather than fixed for floating. For example, a swap might exchange 3-month SOFR for 1-month SOFR plus a spread, or SOFR for another floating rate like the Fed Funds rate. These swaps are useful when a party has assets tied to one rate and liabilities tied to another.

The swap market's flexibility has led to numerous other structures:

• Amortizing swaps: The notional principal decreases over time, matching amortizing loans.
• Accreting swaps: The notional principal increases over time, useful for construction financing.
• Forward-starting swaps: The swap becomes effective at a future date, allowing parties to lock in rates ahead of anticipated funding needs.
• Overnight index swaps (OIS): Exchange a fixed rate for a compounded overnight rate, used extensively for managing short-term funding and as a benchmark for risk-free rates.