Swap
Candlefocus EditorA swap is a contractual agreement between two counterparties to exchange cash flows that are linked to different forms of financial instruments. For example, interest rate swaps involve the exchange of periodic interest payments on a given principal sum (the notional amount) between two parties. In the most basic form of an interest rate swap, one party will pay a fixed interest rate, while the other party will receive the floating rate. Swaps can be used for a variety of purposes, such as hedging interest rate risk, managing corporate balance sheet mismatches and increasing profit from leveraged investments.
Swaps are typically used by entities such as corporations, financial institutions and government bodies.
Swaps are often used to hedge against the risk of changes in the interest rates and market prices of the financial instruments traded. By entering into a swap agreement, one party is able to minimize, or hedge, its exposure to risks associated with changes in financial markets. For example, an investor may enter into a currency swap agreement to eliminate the risk of changes in the exchange rate.
Swaps are also used to take advantage of subsequent changes in the fair value of a financial instrument. For example, if an investor believes that the price of a stock will go up soon, they may enter into a swap agreement with another party, agreeing to exchange its current position in the stock at a fixed exchange rate, but anticipating that its exchange rate will increase when the price of the stock goes up.
Swaps are generally considered to be riskier investments than traditional securities due to their convoluted nature and the complexities of understanding their behavior as a financial instrument. Therefore, swaps should generally only be considered by experienced investors who have a comprehensive understanding of the risks involved.