Tuesday, December 28, 2010

Swap

A swap is a derivative or financial contract that involves an agreement between two parties to swap a future set of cash flows. The cash flows exchanged will be determined by a formula based on a pre-agreed reference price/return/rate and a notional principal amount. For example the most common form of swap is an interest rate swap, which swaps a series of interest payments based on a notional principal; where one interest payment is based on a floating rate, and the other on a fixed rate. Such a swap can be used to hedge or transform exposures, for example a company with fixed rate debt could enter into a swap agreement to receive fixed and pay floating - the pay and receive fixed would net to 0 and the company would be left with floating rate payments; thus effectively transforming their debt interest payments to floating rate payments. For a fund manager, the manager may wish to gain a certain exposure, so for example, they might enter into a swap agreement where it pays LIBOR (a common reference interest rate) and receives the return on the S&P500 index. Swaps can be quite a useful derivative. Swaps are traded OTC, and can thus be tailored to specific needs, but create counter-party risk as the contract is directly with the counter-party.

Synonyms: Derivatives, Swap contract, Swap agreement

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