SWAP
Posted by Ripon Abu Hasnat on Friday, June 13, 2014 | 0 comments
In finance, a swap is a derivative in which counterparties exchange cash
flows of one party's financial instrument for those of the other party's
financial instrument. The benefits in question depend on the type of financial
instruments involved. For example, in the case of a swap involving two bonds,
the benefits in question can be the periodic interest (or coupon) payments
associated with the bonds. Specifically, the two counterparties agree to
exchange one stream of cash flows against another stream. These streams are
called the legs of the
swap. The swap agreement defines the dates when the cash flows are to be paid
and the way they are calculated. Usually at the time when the contract is
initiated at least one of these series of cash flows is determined by a random
or uncertain variable such as an interest rate, foreign exchange rate, equity
price or commodity price.
The cash flows are calculated over a
notional principal amount. Contrary to a future, a forward or an option, the
notional amount is usually not exchanged between counterparties. Consequently,
swaps can be in cash or collateral.
Swaps can be used to hedge certain
risks such as interest rate risk, or to speculate on changes in the expected
direction of underlying prices.
Swaps were first
introduced to the public in 1981 when IBM and the World Bank entered into a
swap agreement. Today, swaps are among the most heavily traded financial
contracts in the world: the total amount of interest rates and currency swaps
outstanding is more than $347 trillion in 2010, according to Bank for
International Settlements (BIS).
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