A Brief Introduction About the Swap Contract
What Is a Swap Contract?
This is a derivative contract. A derivative is a financial tool whose value depends on the underlying asset or group of assets. The price of the derivative depends on fluctuations in the underlying asset. There are cash flows exchanged between the two parties to the contract. While one cash flow is fixed in nature, the other is floating in nature.
How Do Interest Rate Swaps Work?
Swaps contracts where fixed interest rates are exchanged for floating interest rates are called interest rate swaps. The shortcut method can be used for interest rate swap accounting. The fixed interest rate for both the fixed rate the company expects to receive and pay is combined with the fixed rate difference between both for calculating the semi-annual interest expense.
Swap futures are futures contracts based on interest rate swaps. Swap derivatives involve the exchange of cash flows between two parties where the cash flow of the financial instruments of both companies are exchanged between each other. A company that pays variable rates of interest swaps interest payments with another company that will pay them a fixed rate of interest.
Who Takes the Swap Contract? – People Involved
The parties to a swap trade would be two entities who want to exchange each other’s cash flows, which arise from each other financial instruments.
One of the parties would exchange their variable interest financial instrument for the fixed interest financial instrument from another party. This would protect them from any fall in interest rates. The other party would benefit from a rise in interest rates.
Purpose of the Swap Contract – Why Do You Need It?
Time swaps are derivative contracts where a sequence of cash flows between two parties need to take place within a predetermined time.
One of the two cash flows is linked to a random variable, which could be an interest rate, equity price, foreign exchange rate, or commodity price. Swaps are not traded on a public exchange but through a private over the counter deal.
These are customized contracts where firms and financial institutions are the leading players. Swaps face the risk of default from the counter party since they are traded privately over the counter and not on a public exchange.
In case of interest rate swap contracts, party A and party B agree to pay each other a fixed and floating interest rate on a notional principal on specified payment dates known as settlement dates. Interest may be paid monthly, quarterly, annually, or as mutually decided by both parties.
Swap termination or ending of a swap contract can happen as per mutual agreement or as per contract details. Without an agreement, this would become very difficult.
A perpetual swap is a type of derivative contract where there is no contract expiry date or settlement date. Nothing is bought by the buyer, and the seller sells nothing. The traders need to hold a sufficient quantity of the underlying asset to pay for their orders. Traders need to have bitcoins in their accounts.
Contents of the Swap Contract – Inclusions
swap contract must contain certain clauses to protect the parties against swap risk. There are two types of risk, namely interest rate risk and credit risk or counter party risk. Depending on whether the party has chosen the fixed or floating rate of interest, they will gain or lose on the interest rate movements.
When it comes to swaps vs. futures, swaps are contracts where variable performance is exchanged for a fixed rate, whereas futures are agreements where two parties buy or sell a particular commodity at a future date for a predetermined price.
A swap financial is a derivatives contract where one company exchanges the cash flow or value of some asset with another company. An example is a swap involving interest rates.
A swap contract must contain the following information:
- Names of the parties to the contract including all the communication information
- The effective date of the agreement
- The tenure of the contract including the starting and the ending date
- Settlement dates: The dates on which both parties must make their respective interest rates
- Nature of the swap: Whether it is an interest rate swap or a currency swap. If it is a currency swap, then what will be the currency for the principal and the currency for the interest since both currencies will be different. If it is interest rates, then which party has a fixed interest rate and who has the floating rate of interest
- Termination of the contract: The date on which the contract will be terminated unless it is of a perpetual nature
- Confidentiality clause: The information in the contract should not be disclosed to a third party
How to Draft the Swap Contract?
While drafting swap contract, it is essential to understand the law relating to swaps and similar financial instruments.
Here are the points to be considered while drafting the contract:
- Eligibility to contract: Both parties to the contract should be competent to do so. They should not have been coerced to enter the contract
- Consideration for the contract: The payments to be made by both parties and the settlement dates on which they need to be made
- Terms of the contract: The details about the nature of the contract and the underlying security involved. The benchmark rates in case of interest rate contracts
- Confidentiality clause: The parties should not disclose any information relating to the contract to any third party
- Dispute resolution clause: In case of a dispute between the two parties, the contract needs to state whether arbitration or litigation will be considered and the legal jurisdiction where the breach of contract will be resolved
- Termination of a contract clause: If the contract is to be terminated prematurely, then the notice period that each party will have to serve is to be mentioned as well
- Adherence to law: The contract should not be violating the laws of the state applicable to such contracts
- Signatures and dates: The last page of the contract should be reserved for signatures. When the contract is signed, it means that both parties to the contract have understood and terms and agree to them
Before the two parties enter into the swap contract, the terms and conditions should be laid out. The parties should look at the benchmark being used in case of the contract or the currency involved and negotiate with each other to settle on a mutually agreed benchmark or currency. They can decide on the settlement dates and also termination of the contract.
Benefits & Drawbacks of the Swap Contract
The Benefits of a Swap Contract Are as Under:
- Protection of interest: The interest of both parties is protected under this contract. They are assured of payment on the settlement dates, and there will be no credit risk involved
- Termination of contract: Both parties can end the contract before the end date by providing the notice mentioned in the contract
- Legal action: If any party violates the terms of the contract, the injured party will be able to take legal action and claim the damages including loss of profits
- Minimization of disputes: The contract ensures that both parties understand all the clauses and then sign it. This reduces the possibility of disputes
Here Are the Drawbacks of a Swap Contract:
- Non-payment of dues: If there is no contract, then either party to the contract may not make the payments on the settlement date
- No legal recourse: In case of default by the other party, no action can be taken because there is no official agreement between the parties
- Disputes: As there is no legal agreement, both parties may have disputes regarding the settlement dates and other aspects of the trade
- Information leakage: There could be leakage of confidential information related to the business with other parties causing huge losses.
What Happens in Case of Violation?
In such contracts, both parties need to pay each other on the settlement date during the contract period.
Here are the remedies available in case of violation of these contracts:
- Money Damages: The money damages would depend on the kind of breach that has taken place, whether it is a total breach of contract or a partial breach. For a total breach, the damages would include the amount the injured party would receive had the contract been completed, including loss of profits. For partial breach, the injured party would look at the cost of entering into another contract
- Restitution: In this case, there is no monetary compensation involved. The money or property that belonged to the injured party before the contract should be restored to them. The other party might be adjudged incompetent by the court
- Rescission: When this remedy is availed of, the contract is canceled, and the parties to the contract have no further contractual obligations. This is done when it is found that a party has been inducted into the agreement by fraud or undue influence
- Reformation: In case of reformation, the court might find that the terms of the contract are unfair and decide to reframe the contract
- Specific performance: When this remedy is chosen, the party at fault will have to execute the contract, and monetary compensation will not be accepted
A swap contract is mandatory to ensure that both parties to the agreement are protected in terms of payments. Parties need to pay each other on the given settlement date within the contract period. To ensure that neither party is adversely affected, some clauses need to be incorporated.
The confidentiality clause ensures that neither party divulges confidential trade information to third parties, as this would cause considerable losses to the injured party. The clause for termination of the contract is essential so that the parties have the flexibility to exit the contract for any reason. The process of handling disputes, whether through litigation or arbitration, will be mentioned in the dispute resolution clause(1).
The damages payable to the injured party in case of default by either party should also be included in the contract. Both parties to the agreement should read all the terms and conditions carefully before signing it.