DEFINITION of 'Reverse Swap'

A reverse swap is an exchange of cash flow streams that undoes the effects of an existing swap. When investing in derivatives such as futures, forwards, and swaps, there are a handful of ways to exit or cancel an existing contract. One of the ways is to enter into what is called an "offsetting position." An offsetting position is a contract that has the reverse specifications of the original contract, therefore undoing the original contract. Reverse swaps are used, instead of simply canceling the original swap, because they allow investors to avoid negative tax or accounting implications.

Reverse swaps also allow investors to mitigate the original risk that they are exposed to upon entering a swap, or to cancel a position if they feel that market conditions will change in such a way as to give the original swap a negative value.

BREAKING DOWN 'Reverse Swap'

Swaps are private transactions that are traded over the counter, and as such are subject to credit risk. In a swap, this credit risk that the other party may not deliver on their part of the bargain is called "counterparty risk." These contracts exchange assets, liabilities, currencies, securities, equity participations and commodities. They are generally used for risk management by institutions, and are less common among individual investors.

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