Swap

Swap may be explained as an agreement occurring between two contracting investors. Swaps occur when there is an exchange of streams of cash flow among the contracting members.The returns from one asset may be channelized into another financial instrument, which involves less risk.
The script below highlights certain facets of Swap.A Swap may be defined as”cash settled over the counter derivative”. The Swaps are considered as the simplest form of over-the-counter derivative or OTC.

Swap is considered as an agreement, which takes place between two contracting members whereby there is exchange of “two streams of cash flow”. The main factor, which is taken into consideration, is that the values of the exchanging assets should be equal.

First Ever Swap to have taken place:
The first time a swap transaction had taken place was in August 1981. The swap had taken place between IBM and World Bank. In general, swaps have been in vogue during the 1980s.

Categories of Swap:
Depending on the nature in which streams of cash flow are exchanged, Swap may be categorized as:

  • Total return swaps
  • Interest rate swaps
  • Currency swaps

Understanding the working of a Swap:
This may be understood with the help of an instance mentioned below. If an investor is entitled to get returns from equities, instead of liquidating the returns, the investor may swap the returns into any financial instrument, which involves less risk and that, which yields flow of cash income on a fixed basis.
Features of a Swap:
There are several ways in which a Swap may be utilized ranging from speculations to hedging. The main essence of Swap is to alter the characteristics of a liability or an asset without having the need to liquidate the liability or the asset.

There are two possibilities when a stream of cash flow is taking place. The streams are referred as “legs”. The payments of one stream of cash flow may be faster than the other. This gives rise to a market value, which is positive.

The second instance may be pertaining to the market values, which are affected by the market variables. The market values of both the streams of cash flow may differ thereby affecting the difference between cash flow streams.
Netting a swap:
It is ensured that the swaps or payments of the streams of cash flow take place on similar days. This is referred to as “netting of swaps”. This condition is fulfilled if the swap is taking place between currencies, which are identical.

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Last Updated on : 1st August 2013