Swap
Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT
Meaning
A swap is a derivative contract in which two parties agree to exchange streams of cash flows over a period of time. The two main types are:
- Interest rate swap: fixed interest payments are exchanged for floating ones on a notional principal, an agreed amount that is not itself exchanged.
- Currency swap: payments in one currency are exchanged for payments in another.
Swaps let firms and banks change the kind of risk they carry, for example from floating-rate to fixed-rate debt, without taking a new loan.
Example
A firm that has borrowed in dollars but earns in rupees can enter a currency swap. It receives the dollar payments it needs and pays rupees in return, so it no longer has to worry about exchange-rate changes on that debt.
Don't confuse with
- Credit default swap (CDS): despite the name, this is protection against default. The buyer pays regular premiums, and the seller pays only if a named borrower defaults. There is no exchange of two regular payment streams.
Related concepts
- Derivatives
- Forward contract
- Futures
- Options
- Interest rate swap
- Credit default swap
- Commodity derivatives
- Hedging
- Arbitrage
- Futures and options trading