Substitution Swap – Definition

Cite this article as:"Substitution Swap – Definition," in The Business Professor, updated June 10, 2019, last accessed October 27, 2020, https://thebusinessprofessor.com/lesson/substitution-swap-definition/.

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Substitution Swap Definition

Substitution swap is the act of trading security with another security that has similar features and highly rated yields. In this case a money manager exchanges one bond for another that has similar terms of the coupon, credit quality, and maturity as well as offers higher yields.

The substitution swap allows investors to increase their returns without changing the conditions and risks of their portfolio. A swap is initiated by an investor who believes there is incorrect pricing of bonds in the modern market and hopes that the prices of bonds will be readjusted by market activity to generate profit.

Investors engage in substitution swaps when they realize that there is a discrepancy in the prices of bonds as a result of market equilibrium. Substitution swaps enables investors to increase their returns without risking with the security levels.

A Little More On What is a Substitution Swap

A swap of security  usually happens when investment objectives  of an investor maybe changes. For instance, an investors objective in  swapping a security could be to improve the credit quality of the security.

A substitution bond consists of selling  a bond instrument and using the proceeds to purchase a similar or another debt instrument but with a likelihood of a higher return that the former. The main goal why investors engage in substitute swap is to improve financial positions by reducing the investors’ tax liability.

Benefits of Substitute Swap

When investors engage in a substitute swap, they are replacing the bond with another bond through selling and buying. The main aim of doing this is to gain tax benefits. The investor is also able to rewrite off the losses from the bond to lower the tax liability as long as they do not purchase identical bonds sold within 30 days.

Examples of Substitution Swaps

Generally, a substitution swap involves two bonds that are rated corporate with a similar ten percent coupon. For instance, if one bond costs $1000 and another bond costs $950, over the years the bonds are likely to yield an interest that is similar.An investor may swap the expensive bond for the cheaper ones.

Reinvestment of extra returns from selling the expensive bond will increase the percentage of profits from investment since the investor is likely to purchase more bonds. Ultimately substitution swap is usually attractive because of the realized compound yield strategy.

Risks Involved In Substitution Swap

  • They are traded over the counter and are at a higher risk of misguided market interpretation in terms of expected returns.
  • They require a lot of money in order for an investment, which is a risk due to inherent market factors to gain high-profit margins.
  • Substitution swap is generally short-term and relies heavily on the interest rates expectations, thus subject to more risks.
  • For instance, if a country prohibits certain investors from owning a given percentage of shares, using substitution swap the investor can get through the restriction by using a dealer firm as a subsidiary with foreign stock which will be used to gauge the investor’s position. However, this process involves additional costs that result in less favorable terms than those that were already in place

Advantages of Substitution Swap

 

  • Substitution swap results to the realization of capital gain by switching out of a  current position into high yielding obligations.

 

  • Substitution swaps do not incur custodial costs that are associated with the holding of stock and withholding of taxes on foreign stock indices. They, however, suffer some additional charges for legal and documentation which are relatively small.
  • Substitution swaps are usually customized to any stock and index portfolio, which is the best way of investing in a market that is not accessible. The swaps enable one to invest freely in the foreign markets without being worried about restrictions that may hinder foreigners from owning a large number of stocks given.
  • Substitution swaps are not susceptible to manipulation since the payment is based on the rate of return. Therefore any attempt to manipulate the prices of stock at the end of the period will result in effects that will be carried over to the next period.

Disadvantages of Substitution Swaps:

  • Substitution swaps are thought to be temporary hence reducing the capital gains and this affects the market range adversely.
  • The substitution swaps have significant cash flows that are large and require funding.When the cash flows are not affected by increases in stock positions they result in liquidated cash flows, this, therefore, offsets the primary attractions of substitution swaps that avoid engaging in a transaction of actual securities.
  • Being a derivative, substitution swaps have a termination date unlike with other securities traded in the market.
  • Substitution swaps are subject to credit risk; they may not be the case when investing in substitution directly. Ultimately substitution swap users assume the risk that the dealer is in default.

In conclusion, in recent past substitution swap have emerged to be a series of derivatives that plays an integral part in how the funds are gaining exposure in the global market. The increased popularity of the substitution swaps is underpinned by the advantages mentioned earlier. Substitution swaps can be used for trading with other equities in connection with a wide range of additional services based on the requirements of the funds.

Reference for Substitution Swap

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