Swaps: Terminologies used in Swaps; Types of Swaps - Interest Rate Swaps - Caps and Floors,
Equity Swaps, Commodity Swaps, Currency Swaps and Credit Derivatives.
Introduction
The forward, future and option contracts are generally short-term contracts and help individuals
and institutions to hedge risk in the short term. They can be used to hedge long-term risk by
rolling over the contracts from one short term to another, but this strategy can result in losses
if the underlying asset prices move against the hedger. Therefore, there was a need for
developing an instrument that could be useful in hedging over a long term. Th e instrument
created for this purpose was the swap contract.
Meaning of Swaps
Swaps are private agreements between two parties to exchange one stream of future cash flows
for another stream of cash flows in accordance with a pre-arranged formula. Th e agreement
provides details of how the cash flows will be calculated and the dates on which the cash flows
will be exchanged. At the time the contract is entered into, at least one of these cash flows will
be determined on the basis of an uncertain variable such as interest rate, exchange rate, equity
price, or commodity price, while the other could either be a fixed payment or be determined on
the basis of another uncertain variable.
Similarity of Swaps and Forward Contracts
A swap is a periodic exchange of cash flows under specified rules. A forward contract can be
viewed as a simple example of a swap. Suppose it is March 1, 2022, and a company enters into
a forward contract to buy 100 ounces of gold for $1,700 per ounce in one year. The company
can sell the gold in one year as soon as it is received. The forward contract is therefore
equivalent to a swap where the company agrees that on March 1, 2023, it will pay $170,000
and receive 100S, where S is the market price of one ounce of gold on that date. Whereas a
forward contract is equivalent to the exchange of cash flows on just one future date, swaps
typically lead to cash-flow exchanges taking place on several future dates.
,Features of Swaps
Swaps are the combination of forwards by two counterparties. It is arranged to reap the benefits
arising from the fluctuations in the market (either currency market or interest rate market or
any other market for that matter).
The following are the important features of swaps.
,
Equity Swaps, Commodity Swaps, Currency Swaps and Credit Derivatives.
Introduction
The forward, future and option contracts are generally short-term contracts and help individuals
and institutions to hedge risk in the short term. They can be used to hedge long-term risk by
rolling over the contracts from one short term to another, but this strategy can result in losses
if the underlying asset prices move against the hedger. Therefore, there was a need for
developing an instrument that could be useful in hedging over a long term. Th e instrument
created for this purpose was the swap contract.
Meaning of Swaps
Swaps are private agreements between two parties to exchange one stream of future cash flows
for another stream of cash flows in accordance with a pre-arranged formula. Th e agreement
provides details of how the cash flows will be calculated and the dates on which the cash flows
will be exchanged. At the time the contract is entered into, at least one of these cash flows will
be determined on the basis of an uncertain variable such as interest rate, exchange rate, equity
price, or commodity price, while the other could either be a fixed payment or be determined on
the basis of another uncertain variable.
Similarity of Swaps and Forward Contracts
A swap is a periodic exchange of cash flows under specified rules. A forward contract can be
viewed as a simple example of a swap. Suppose it is March 1, 2022, and a company enters into
a forward contract to buy 100 ounces of gold for $1,700 per ounce in one year. The company
can sell the gold in one year as soon as it is received. The forward contract is therefore
equivalent to a swap where the company agrees that on March 1, 2023, it will pay $170,000
and receive 100S, where S is the market price of one ounce of gold on that date. Whereas a
forward contract is equivalent to the exchange of cash flows on just one future date, swaps
typically lead to cash-flow exchanges taking place on several future dates.
,Features of Swaps
Swaps are the combination of forwards by two counterparties. It is arranged to reap the benefits
arising from the fluctuations in the market (either currency market or interest rate market or
any other market for that matter).
The following are the important features of swaps.
,
