A swap is one of the most simple and successful forms of OTC-traded derivatives. It is a cash-settled contract between two parties to exchange (or "swap") cash flow streams. As long as the present value of the streams is equal, swaps can entail almost any type of future cash flow. They are most often used to change the character of an asset or liability without actually having to liquidate that asset or liability. For example, an investor holding common stock can exchange the returns from that investment for lower risk fixed income cash flows - without having to liquidate his equity position.
 

The difference between a forward contract and a swap is that a swap involves a series of payments in the future, whereas a forward has a single future payment.

Two of the most basic swaps are:

Interest Rate Swap - This is a contract to exchange cash flow streams that might be associated with some fixed income obligations. The most popular interest rate swaps are fixed-for-floating swaps, under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan.

Currency Swap - This is similar to an interest rate swap except that the cash flows are in different currencies. Currency swaps can be used to exploit inefficiencies in international debt markets.

For example, assume that a corporation needs to borrow $10 million euros and the best rate it can negotiate is a fixed 6.7%. In the U.S., lenders are offering 6.45% on a comparable loan. The corporation could take the U.S. loan and then find a third party willing to swap it into an equivalent euro loan. By doing so, the firm would obtain its euros at more favorable terms. Cash flow streams are often structured so that payments are synchronized, or occur on the same dates. This allows cash flows to be netted against each other (so long as the cash flows are in the same currency). Typically, the principal (or notional) amounts of the loans are netted to zero and the periodic interest payments are scheduled to occur on that same dates so they can also be netted against one another.

As is obvious from the above example, swaps are private, negotiated and mostly unregulated transactions (although FASB 133 has begun to impose some regulations).



Purposes and Benefits of Derivatives

Related Articles
  1. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  3. Trading

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  4. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  5. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  6. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  7. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  8. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  9. Investing

    A Guide To Real Estate Derivatives

    These instruments provide exposure to the real estate market without having to buy and sell property.
  10. Investing

    China Will Let Banks Swap Bad Debt for Equity

    Regulators are contemplating allowing banks to swap bad debt for equity in defaulting companies but such a move can increase the riskiness of banks' balance sheets.
Frequently Asked Questions
  1. Why is social responsibility important to a business?

    Take social responsibility seriously, and your business could benefit from happier, more productive staff members while helping ...
  2. Which socially responsible retailers appeal most to ethical investors?

    Learn why ethical investors have many options in the retail sector, and discover which retail companies are most popular ...
  3. What are Some Examples of Free Market Economies?

    Learn which of the world's economies best resemble free market economies, marked by free trade, low government involvement, ...
  4. Who Decides When to Print money in India?

    Find out the role of the Reserve Bank of India, or RBI, and the amount of authority given to the government. Learn who is ...
Trading Center