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Introduction to swaps
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Let us today discuss about ‘Swaps’ in finance. Swaps are simply financial agreements to exchange cash flows. These are simply private arrangements between parties to exchange cash flows according to some pre-arranged formula. The parties to the contract are called counter-parties.

In these contracts, one party agrees to exchange his set of pre-determined cash flows with the pre-determined set of cash flows of the other party. Swaps are, thus, contracts that exchange assets, liabilities, currencies, securities, equity participations and commodities.

Some are simple, such as floating-for-fixed-rate loans or Japanese yen (JPY) for British pound sterling (GBP), while others are quite complex incorporating multiple currencies, interest rates, commodities and options. Both types are flexible in terms of specifications such as pricing or evaluation benchmarks, timing or contractual horizons, settlement procedures, and other variables. For instance, one party is receiving cash from one investment but prefers to have cash flows from other type of investment. The cash flows are swapped (exchanged) with the help of a swap dealer.

Generally, swaps are used for risk management by institutions such as banks, brokers, dealers and corporations. Some qualified individuals may also be suitable users of these basic derivatives products. Some characteristics of swaps are as follows:

  1. Swaps are not subject to regulations as in case of futures and options.
  2. When initiated, neither party exchanges any cash; a swap has zero value at the beginning.
  3. Generally involve multiple payments, although one-payment contracts are possible.
  4. One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that both parties pay each other on the movement of an underlying asset. Hence, these contracts are tailor-made to the needs of counter-parties.
  5. Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other; which is called netting.
  6. Final payment is made on the termination date.
  7. These contracts are usually traded in the over-the-counter market, which means they are subject to credit risk.

As the swaps are private arrangements between the parties, different types of swaps have emerged over the years. Swaps are, in fact, a part of financial engineering and attempt to cope up with the requirements of a party. We shall take up different types of swaps in an upcoming blog.

References:

Rustagi, Dr. R.P., Investment Management: Theory and Practice (2008)

 

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