A:

The main purpose of swap agreements is to swap cash flows between counterparties for a certain market or asset. Generally, most swap agreements are entered into to hedge a certain type of risk for one party, while the other party seeks to profit on the possible fluctuations in value for the assumed risk.

A swap is a derivative traded over the counter, which allows the parties to exchange a series of cash flows for a certain time frame. Swaps have two main components: the fixed leg and the floating leg. The fixed leg is the hedge side of the swap, where the party is seeking to control risk as to certain fluctuations in price or a market. The floating side is seeking to profit from a change in the relative rate or value granted to the counterparty by the fixed leg.

There are numerous types of swaps, including interest rate swaps, currency swaps, security-based swaps and commodity swaps. Swaps are used extensively by oil and gas producers to hedge their exposure to volatile oil and gas prices. By selling swaps, producers can lock in a definite price for a portion of their oil production, allowing them to have certainty for future cash flows. The counterparty buys the swap, betting the price of oil will be either higher or lower than the price set forth in the swap agreement. The same principles apply to other types of swaps, although the product or market being hedged differs.

Defaults on credit default swaps were cited as one of the reasons for the 2008 financial crisis. As a result, the U.S. government enacted the provisions of the Dodd-Frank Act, which seeks to centralize information regarding swap agreements and reduce systemic risk caused by swap trading.

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