The following are the important characteristics of swap contracts:
Basically a Forward
A swap is nothing but a combination of forwards. So, it has all the properties of a forwarding contract.
Double Coincidence of Wants
A swap requires that two parties with equal and opposite needs must come into contact with each other, i.e., the rate of interest differs from market to market and within the market itself.
Comparative Credit Advantage
Borrowers enjoying a comparative credit advantage in floating rate debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying a comparative advantage in fixed interest rate debt, like bonds.
In the bond market, lending is done at a fixed rate for a long duration, and therefore, the lenders do not have the opportunity to adjust the interest rate according to the situation prevailing in the market.
In the short-term market, the lenders have the flexibility to adjust the floating interest rate (short-term rate) according to the conditions prevailing in the market as well as the current financial position of the borrower.
Necessity of an Intermediary
A swap requires the existence of two counterparties with opposite but matching needs.
This has created a necessity for an intermediary to cancel both parties.
Though a specified principal amount is mentioned in the swap agreement, there is no exchange of principal.
On the other hand, a stream of fixed-rate interest is exchanged for a floating rate of interest, and thus, there are streams of cash flows rather than a single payment.
Generally, forwards are arranged for a short period only. Long-dated forward rate contracts are not preferred because they involve more risks, for example, risk of default, risk of interest rate fluctuations, etc.