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STRUCTURE
Swaps are Over-the-counter (OTC) Derivatives . This means that they are negotiated outside exchanges. They cannot be bought and sold like Securities or Futures Contract s, but are all unique. As each swap is a unique contract, the only way to get out of it is by either mutually agreeing to tear it up, or by reassigning the swap to a third party. This latter option is only possible with the consent of the counterparty. The Bank For International Settlements (BIS) publishes statistics on the Notional Amount s outstanding in the OTC Derivatives market. At the end of 2004, this was USD 248.288 trillion (that is, USD 248,288 billion, or six times World GDP ). The majority of this (USD 147.4 trillion) were Interest Rate Swap s. These split by currency as: :''Source: "The Global OTC Derivatives Market at end-December 2004", BIS'', {Link without Title} '' Usually, at least one of the legs has a rate that is ''variable''. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any Conflict Of Interest . For instance, LIBOR is set by the British Bankers Association , an independent trade body. INTEREST RATE SWAP See Also: interest rate swap Interest Rate swaps are the most common type of swap, also known as a 'plain vanilla' swap. They typically exchange fixed rate payments against floating rate payments. The principals are not exchanged, and are known as the notional principal. Exceptions exist, such as floating-to-floating swaps (known as ''basis swaps''). TOTAL RETURN SWAP See Also: total return swap A total return swap is a swap, where party A pays the ''total return'' of an Asset , and party B makes periodic interest payments. The ''total return'' is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the Underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset. EQUITY SWAP See Also: equity swap An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do have. VALUATION The value of a swap is the Net Present Value (NPV) of all future cash flows. Initially, the terms of a swap contract are such that the NPV of all future Cash Flow s is equal to zero. For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the ''fixed rate'' would be such that the present value of future fixed rate payments by Party A are equal to the present value of the ''expected'' future floating rate payments (i.e. the NPV is zero). Were this not the case, an Arbitrage ur, C, could: # assume the position with the ''lower'' present value of payments, and borrow funds equal to this present value # meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value # use the received payments to repay the debt on the borrowed funds # pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit. ''See: Rational Pricing ; Arbitrage '' VARIATIONS Variations of swaps include Cross Currency Swap s, amortizing swaps and so on. OPTIONS An option on a swap is called a Swaption . SEE ALSO EXTERNAL LINKS
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