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
counter-parties 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).
