The most common type of swap is an interest rate swap. Swaps are not traded on stock markets and retail investors generally do not participate in swaps. On the contrary, swaps are out-of-three contracts, mainly between companies or financial institutions, tailored to the needs of both parties. The most common and simplest swap is a «plain Vanilla» interest rate swap. In this exchange, Party A undertakes to pay Party B a predetermined fixed interest rate for fictitious capital on specified dates for a specified period. At the same time, Party B undertakes to make payments on the basis of a variable interest rate to Part A on the same notional capital on the same days fixed for the same given period. In a simple vanilla exchange, both cash flows are paid in the same currency. The payment dates shown are called settlement dates and the interim periods are called billing periods. As swaps are tailor-made contracts, interest payments can be made annually, quarterly, monthly or at another interval set by the parties. Unlike most standardized options and futures, swaps are not exchange-traded instruments. Instead, swaps are bespoke contracts traded on the over-the-counter (OTC) market between private parties. Companies and financial institutions dominate the swap market, and few (if any) individuals participate.
Since swaps take place in the OTC market, there is always a risk of a counterparty defaulting during the swap. The first interest rate swap took place in 1981 between IBM and the World Bank. In 1987, the International Swaps and Derivatives Association reported that the swap market had a total value of $865.6 billion. By mid-2006, according to the Bank for International Settlements, that figure had exceeded $250 trillion. That`s more than 15 times the size of the U.S. public market. According to the SEF 2018 market share statistics, Bloomberg dominates the credit market with an 80% share, TP dominates the FX dealer market (46%), Reuters dominates the customer dealer market (50%), Tradeweb is the strongest in the vanilla market (38% share), TP the largest platform in the core swap market (53%) and BGC dominates both the swaption and XCS markets, Tradition is the largest platform for caps and floors (55%). In most cases, both parties would act through a bank or other intermediary that would take a swap cut. Whether it is advantageous for two companies to enter into an interest rate swap depends on their comparative advantage in the fixed-rate or variable-rate loan markets. In the case of an interest rate swap, the parties exchange cash flows on the basis of a notional nominal amount (this amount is not actually exchanged) to hedge or speculate against interest rate risks. Imagine, for example, that ABC Co.
just issued US$1 million in five-year bonds with a variable annual interest rate, defined as London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). . . .