Price Swap Derivative

What Is a Price Swap Derivative?

A price swap derivative is a derivative transaction where one entity guarantees a fixed value for the total asset holdings of another entity over a specified period. Under this type of agreement, whenever the value of the secured assets declines, the counterparty must deliver securities or other collateral to offset that loss and bring the asset back to its original value.

Understanding a Price Swap Derivative

Price swap derivatives enable the value of one company’s assets to stay constant over a set period through the help of another company’s distributing shares. In this sense, the price swap derivative can effectively hide the fact that the receiving company’s financial position is weakening over time. However, when the counterparty issues new shares to fill the gap created by the lowered asset, it results in dilution of value for existing shareholders. This combination of a misleading valuation on one side and increasingly diluted stock on the other can destabilize the financial standing of both parties in the agreement. 

Today, price swap derivatives are relatively unusual transactions. Their rareness is due to changes in accounting rules and the availability of more common methods to insure against declines in asset values. 

A more common derivative is known as a futures contract. With a futures contract, one party agrees to sell an asset to another party at a preset price on a predetermined future date. An additional type of derivative that can be used to insure against declines in asset values is called an option. Options are a derivative similar to futures; the chief difference is that the buyer is not required to purchase assets when the future date arrives.

Example of a Price Swap Derivative

Price swap derivatives were made famous as a result of the Enron financial scandal. Enron used price swap derivatives to guarantee the value of one of its subsidiaries, a limited partnership named Raptor. Under the derivative transaction, whenever Raptor’s assets fell below $1.2 billion, Enron promised to give enough stock to the subsidiary to make up the difference and keep Raptor assets at a constant.

As this repeatedly happened over time, Enron stock made up an increasing portion of Raptor’s total assets. This practice only increased the need to trigger transactions, since whenever Enron’s stock fell, it would also bring Raptor assets below the $1.2 billion threshold. This downward spiral continued to force Enron to issue additional shares to the subsidiary. While the accelerating derivative transactions diluted stock values for Enron shareholders, they also prevented the company from having to record the plummeting value of the subsidiary, resulting in helping to inflate its bottom line on regular financial statements.