Introduction

In addition to the well-known interest rate and currency swaps, the world of financial derivatives has given rise to a diverse array of specialized swaps that cater to specific risk management needs and investment strategies. In this chapter, we will explore several other types of swaps, including commodity swaps, volatility swaps, credit default swaps, and exotic swaps. Each of these swaps serves a unique purpose and operates within distinct market contexts. Understanding these less conventional swaps is crucial for comprehending the full scope of swap instruments and their applications in modern financial markets.

Commodity Swaps

Commodity swaps are agreements in which two parties exchange cash flows based on the price fluctuations of a specific commodity. These swaps are employed by entities seeking to manage their exposure to commodity price risks. For instance, an oil producer might enter into a commodity swap to lock in a fixed price for their future oil production, mitigating the impact of price volatility. The cash flows exchanged in commodity swaps are typically based on the difference between the agreed-upon fixed price and the actual market price of the commodity at specified intervals.

The cash flow for a commodity swap is calculated using below formula:

$$\text{Cash Flow = (Agreed Fixed Price - Actual Market Price)} \times \text{Quantity of Commodity}$$

Volatility Swaps

Volatility swaps provide a mechanism to manage volatility risk, which is the uncertainty associated with the price fluctuations of financial instruments. In a volatility swap, one party agrees to pay the other party based on the realized volatility of an underlying asset over a predetermined period. These swaps are valuable tools for investors looking to hedge against or speculate on market volatility.

The payout for volatility swap is calculated using below formula:

$$\text{Payout = Notional Amount} \times \text{(Realized Volatility - Strike Volatility)}$$

Credit Default Swaps (CDS)

Credit default swaps are contracts that allow one party to transfer the credit risk of a specific financial instrument (such as a bond or loan) to another party. The protection buyer makes regular payments to the protection seller, and in the event of a credit event (e.g., default, bankruptcy) involving the underlying instrument, the protection seller compensates the protection buyer. CDS are widely used to manage credit risk exposure.

Exotic Swaps

Exotic swaps encompass a wide range of non-traditional swap structures that are tailored to address specific risk exposures or investment objectives. Examples include equity swaps, where cash flows are tied to the performance of a stock index, and cross-currency swaps with embedded options. These swaps often involve more complex payout structures and are typically customized to meet the unique needs of the parties involved.