What is a Swap?
A swap is a derivative contract between two parties that involves the exchange of pre-agreed cash flows of two financial instruments. The cash flows are usually determined using the notional principal amount (a predetermined nominal value). Each stream of the cash flows is called a “leg.”
Introduced in the late 1980s, swaps are a relatively new type of derivative. Even though relatively new, their simplicity, coupled with their extensive applications, makes them one of the most frequently traded financial contracts.
Corporate finance professionals may use swap contracts to hedge risk and minimize the uncertainty of certain operations. For example, sometimes projects can be exposed to exchange rate risk and the Company’s CFO may use a currency swap contract as a hedging instrument.
Unlike futures and options, swaps are not traded on exchanges but over-the-counter. In addition, counterparties in swaps are usually companies and financial organizations and not individuals, because there is always a high risk of counterparty default in swap contracts.
Some financial institutions usually participate as the market makers of swap markets. The institutions, which are also known as swap banks, facilitate the transactions by matching counterparties.
Types of Swaps
Modern financial markets employ a wide selection of such derivatives, suitable for different purposes. The most popular types include:
Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount. Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate.
Counterparties exchange the principal amount and interest payments denominated in different currencies. These contracts swaps are often used to hedge another investment position against currency exchange rate fluctuations.
These derivatives are designed to exchange floating cash flows that are based on a commodity’s spot price for fixed cash flows determined by a pre-agreed price of a commodity. Despite its name, commodity swaps do not involve the exchange of the actual commodity.
A CDS provides insurance from the default of a debt instrument. The buyer of a swap transfers to the seller the premium payments. In case the asset defaults, the seller will reimburse the buyer the face value of the defaulted asset, while the asset will be transferred from the buyer to the seller. Credit default swaps became somewhat notorious due to their impact on the 2008 Global Financial Crisis.
Applications of Swaps
Nowadays, swaps are an essential part of modern finance. They can be used in the following ways:
#1 Risk hedging
One of the primary functions of swaps is the hedging of risks. For example, interest rate swaps can hedge against interest rate fluctuations, and currency swaps are used to hedge against currency exchange rate fluctuations.
#2 Access to new markets
Companies can use swaps as a tool for accessing previously unavailable markets. For example, a US company can opt to enter into a currency swap with a British company to access the more attractive dollar-to-pound exchange rate, because the UK-based firm can borrow domestically at a lower rate.
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