Swap refers to the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or because investment objectives have changed. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party. Other types of swap are: Currency swap, Debt swap, Debt to equity swap, and Debt to debt swap.
A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties.
What Is the Purpose of a Swap?
A swap allows counterparties to exchange cash flows. For instance, an entity receiving or paying a fixed interest rate may prefer to swap that for a variable rate (or vice-versa). Or, the holder of a cash-flow generating asset may wish to swap that for the cash flows of a different asset. The purpose of such a swap is to manage risk, to obtain funding at a more favorable rate than would be available through other means, or to speculate on future differences between the swapped cash flows.
How Is a Swap Structured?
A swap is an over-the-counter (OTC) derivative product that typically involves two counterparties that agree to exchange cash flows over a certain time period, such as a year. The exact terms of the swap agreement are negotiated by the counterparties and are then formalized in a legal contract. These terms will include precisely what is to be swapped and to whom, the notional amount of the principal, the maturity of the contract, and any contingencies. The cash flows that are ultimately exchanged are computed based on the terms of the contract, which maybe an interest rate, index, or other underlying financial instrument.