A swap is a financial contract where two parties agree to exchange different types of cash flows over a set period. The most common type is an interest rate swap. Swaps are used for risk management, hedging against interest rate or currency changes, or speculating on future market trends. They are usually traded over-the-counter (OTC).
Swaps come in various forms, each designed for different needs. Some common types are:
Interest Rate Swap:
This swap type involves exchanging interest rate payments based on a specific amount. One party pays a fixed rate, and the other pays a floating rate.
In this swap, parties exchange cash flows based on a commodity price like oil or gold. It helps manage price risk for businesses involved with commodities.
This involves exchanging principal and interest payments in different currencies. It allows each party to secure funding in their desired currency without foreign exchange risk.
Credit Default Swap:
In this swap, one party pays a premium for protection against a third party's debt default.
Here, parties exchange cash flows based on a stock or equity index's performance. It's used for risk management or to speculate on future stock or index performance.
Swaps are used for risk management, hedging, and speculation. Common uses include:
Interest rate swaps help manage interest rate risk. They allow companies or investors to hedge against interest rate changes. A company with a floating rate loan might use a swap to convert the floating rate into a fixed one, reducing the risk of rising rates.
Currency swaps help manage currency risk. They allow companies or investors to hedge against exchange rate fluctuations. A company with foreign currency-denominated debt might use a swap to convert the debt into their domestic currency, reducing currency fluctuation risk.