Lesson 8 of 9
A swap is an agreement between two parties where they agree to exchange the cash flows on different assets for a specified period of time. For example, in a vanilla interest rate swap, two parties agree to exchange the interest obligations on their loans. One party pays interest based on a floating interest rate while the other pays a fixed rate. Swaps have a fixed maturity and naturally expire once the maturity reaches. However, the parties involved in a swap transaction may also terminate the contract before its expiry. Let’s look at the different ways in which a swap can be terminated.
1. By Mutual Agreement or as per Contract Details
When a swap contract is initiated it has zero value. However, as time passes and circumstances change, the swap will be more valuable to one party than the other party. This value is called the market value. If both parties mutually decide to go for swap termination, they can do so by exchange this market value. For example, if one party holding the swap has a positive market value of $100,000, then the swap can be settled if the other party pays $100,000 to the party with positive value. To be able to settle a swap in this way either both parties should agree or there should be a provision for this in the swap agreement.
2. By Entering into an Offsetting Swap
A swap can also be terminated indirectly by entering into a similar swap agreement that offsets the original contract. For example, let’s say we have a swap contract where we pay fixed (5%) and receive floating (LIBOR). Now we can terminate this contract, by entering into a new swap agreement with same or different counterparty where we pay floating (LIBOR) and receive fixed. The fixed rate in the new contract will be decided based on the current market conditions but the floating rates will offset. However, this method will not eliminate the default risk.
3. By Selling the Swap
A swap can also be terminated by selling it to another counterparty. If one party wants to exit the swap contract, and the swap is worth $100,000, it can take consent from its counterparty and place another counterparty in its own place to make the swap payments. In effect, the swap is sold for $100,000.
4. By Using a Swaption
The swap can also be terminated by using swaptions. A swaption provides option holder the option to enter into a swap. A party can use a swaption to enter into an offsetting swap.