What is a ‘Swap’ A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises of investopedia forex swap points leg of the swap.
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 contracts between businesses or financial institutions. They find another company, XYZ Inc. ABC an annual rate of LIBOR? In other words, XYZ will fund ABC’s interest payments on its latest bond issue. ABC benefits from the swap if rates rise significantly over the next five years.
XYZ benefits if rates fall, stay flat or rise only gradually. At year 1, the interest rate will be 1. Therefore, Year 1 interest payments rate is 1. Note than in most cases, the two parties would act through a bank or other intermediary, which would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on their comparative advantage in fixed or floating rate lending markets. Other Swaps The instruments exchanged in a swap do not have to be interest payments. Countless varieties of exotic swap agreements exist, but relatively common arrangements include commodity swaps, currency swaps, debt swaps, and total return swaps.
Commodity swaps involve the exchange of a floating commodity price, such as the Brent Crude oil spot price, for a set price over an agreed-upon period. As this example suggests, commodity swaps most commonly involve crude oil. In a currency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Unlike an interest rate swap, the principal is not a notional amount, but is exchanged along with interest obligations. Currency swaps can take place between countries, for example, China has entered into a swap with Argentina, helping the latter stabilize its foreign reserves. It is a way for companies to refinance their debt or re-allocate their capital structure. In a total return swap, the total return from an asset is exchanged for a fixed interest rate.
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