If you are to jot down everything associated with the finance world on a piece of paper, you will probably run out of space. Without a doubt, the jargons involved are so many that it takes time for an individual to learn most of them. Besides the regular generalized terms such as money, exchange, and transactions, we do have ones that have a different meaning when used grammatically and in the commercial world. And one such word is swap.
In the Engish dialect, a swap means a switch or an exchange. And in the Business world, a financial swap is a derivative deal through which two parties in business exchange cash flows from two different financial instruments.
How do financial swaps work?
Most financial swaps involve the exchange of cash flows related to a notion amount such as a loan or a bond and can be done on basically any instrument. The principals, however, do not change hands. Each swap consists of two legs, which is the reference instrument of the trade where each party has one leg. One cash flow is usually fixed, while the other is variable depending on the benchmark interest rate.
Unlike most financial trades, swap meaning trade is based on an over-the-counter agreement and is tailored according to the stipulations of the clients.
Types of Swaps
1. Interest rate swap
This is perhaps the most popular form of exchange that includes an agreement of two parties to pay each other in interest rates. In an interest swap, the involved parties switch cash flows based on a notion principal amount, that is not changed, to hedge against interest rate risk. This swap is one where party X agrees to pay Party Y based on a fixed interest rate, and party Y agrees to make payments to party X based on a floating interest rate. And most times, the floating rate is tied to a reference rate, such as a bank’s.
2. Currency swaps
Currency swaps are likely operated between countries. This swap involves a scenario that the parties exchange interest and principal payments on debt designated in different countries. The principal, in this case, is not based on a notional amount, but it is exchanged alongside the interest obligations.
3. Total return swaps
This form of exchange involves the total return from an asset switched for a fixed interest rate. In this case, the paying party is exposed to the underlying asset, which in most cases, is a stock or an index.
4. Debt-equity swaps
This swap entails the exchange of debt for equity. For instance, a publicly-owned company pays using bonds and stocks of their own company to settle debts.
5. Commodity swap
This swap entails the exchange of an inflated commodity price for a set amount over an agreed time stipulation. Most times, this swap involves crude oil.
6. Credit default swaps
Lastly, we have the CDS, which consists of a deal by one party to pay the lost principal and interest of a loan to the credit default swap buyer when the borrower defaults on paying a loan.
