A swap is an agreement to a future exchange of one asset for another, one liability for another, or more specifically, one stream of cash flows for another.
A swap is a private agreement between two parties in which both parties are obligated to exchange some specified cash flows at periodic intervals for a fixed period of time.
Unlike a forward or a futures contract, a swap agreement generally involves multiple future points of exchange.
The cash flows of a swap may be fixed in advance or adjusted for each settlement date by reference to some specified interest rate, such as MIBOR, LIBOR, or another market yield.
On the settlement date, a difference cheque is paid by whichever party in the swap is obligated to pay more cash than is to be received at the settlement date.
For example, an investor realizing returns from an equity investment can swap those returns into less risky fixed-income cash flows – without having to liquidate the equities.
A corporation with floating rate debt can swap that debt into a fixed rate obligation – without having to retire and re-issue debt.
Swaps can be used to manage risk in the following ways
- Swaps can be used to lower borrowing costs and generate higher investment returns.
- Swaps can be used to transform floating-rate assets into fixed-rate assets and vice versa.
- Swaps can be used to transform floating rate liabilities into fixed-rate liabilities and vice versa.
- Swaps can be used to transform the currency behind any asset or liability into a different currency.