Swaps

What are Swaps?

Swaps are financial contracts where two parties agree to exchange cash flows or liabilities based on different financial instruments over a set period. They're mainly used to manage risk, such as hedging against interest rate or currency fluctuations, and to speculate on future market changes.

Key Points About Swaps

Cash Flow Exchange: In a swap, the two parties exchange cash flows based on a notional amount (which isn’t actually exchanged). One cash flow is usually fixed, and the other is variable, tied to an index like an interest rate or currency exchange rate.

Over-the-Counter (OTC): Swaps are usually traded directly between parties, not on exchanges, allowing for more customization to suit specific needs.

Common Types of Swaps

Interest Rate Swaps: One party pays a fixed interest rate while receiving a variable rate, helping manage interest rate risks.

Currency Swaps: Involve exchanging payments in different currencies, useful for managing currency risk.

Commodity Swaps: Cash flows are based on the price of a commodity like oil or gold, helping businesses manage commodity price risks.

Credit Default Swaps (CDS): One party pays for protection against the risk of a third party defaulting on its debt.

Equity Swaps: Cash flows are based on the performance of a stock index.

Uses of Swaps

Risk Management: Companies use swaps to protect themselves against risks like interest rate changes or currency fluctuations.

Funding Optimization: Companies can adjust their debt structure by using swaps, such as converting fixed-rate debt into floating-rate debt to benefit from lower rates.