A Swap is an agreement between two parties (the counterparties) to exchange a series of future cash flows at specified future times according to pre-specified conditions, typically with a notional principal and a stated maturity, often close to the date of the last cash flow.
The most common type is an Interest Rate Swap. An interest rate swap is a contractual agreement between two counterparties under which each agrees to make periodic payment to the other for an agreed period of time based upon a notional amount of principal. The principal amount is notional because there is no need to exchange actual amounts of principal in a single currency transaction: there is no foreign exchange component to be taken account of. Equally, however, a notional amount of principal is required in order to compute the actual cash amounts that will be periodically exchanged.
Under the commonest form of interest rate swap, a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. This is a fixed-for-floating interest rate swap. Alternatively, both series of cash flows to be exchanged could be calculated using floating rates of interest but floating rates that are based upon different underlying indices. Examples might be Libor and commercial paper or Treasury bills and Libor and this form of interest rate swap is known as a basis or money market swap.
Another common type of swap is Currency Swaps. It is contract which commits two counter-parties to exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity. In a currency swap, there is no exchange rate risk since the rate is set at the beginning of the contract.
Risks
In summary, dealing in swap may involve risks including, but not limited, to the following: Interest rate risks, liquidity risk, credit risk and country risk.
