As a trader gains experience, sophisticated instruments, such as swaps, might become interesting alternatives to stocks and bonds. A swap is a contract in which two parties exchange cash. Traders use swaps to make money or reduce risk. Many types of swaps are available, but the easiest to understand is an interest rate swap. A back-to-back swap is a way to reverse the flows of cash from another swap. It takes three parties to complete a back-to-back swap.
In this extended example, Party A is a bank. It makes fixed rate loans and pays a floating rate on deposits. It faces the risk of rising interest rates, which will increase the interest it pays to savers. To hedge this risk, it agrees to a one-year interest rate swap with Party B for a "notional" amount of $100 million. This isn’t a loan, but a reference number to calculate cash flows. The swap requires Party A to pay out, say, a 6 percent annual rate and get a floating rate on the notional amount. In this way, Party A reduces the risk of higher interest rates. The parties exchange cash flows monthly.
Party B is a trading desk at a hedge fund. The trader is convinced interest rates are heading lower and wants to make a bet on her belief. She agrees to accept a fixed-rate cash flow from and pays a floating rate to Party A. The rate she pays is tied to a well-known interest rate index, such as LIBOR. Every month, Party B pays Party A interest on the $100 million notional based on the one-month LIBOR. Party B gets its 6 percent annual rate, which works out to $500,000.
Three months into the one-year swap contract, Party B begins to doubt its interest rate forecast. It can’t kill the swap with Party A without shelling out hefty early-termination fees. Instead, Party B creates a reverse, or back-to-back, swap with Party C, a pension fund that makes variable rate loans. Party C agrees to fork over the one-month LIBOR for 6 percent annual fixed interest on a $100 million notional amount. The back-to-back swap exactly reverses, or "countervails," the original swap, which ends Party B’s bet on interest rates.
Each party in the back-to-back swap gets fixed or floating cash flows. Party B hedged its risk without paying termination fees. However, if Party C defaults on its swap obligations, Party B’s risk will resume and it'll have to make new arrangements. Back-to-back swaps are also frequently used in currency swaps. These are transactions in which the parties exchange cash flows based on the exchange rate between two different currencies. Parties normally add the inflows and outflows, and exchange only the profit each month.