A financial swap is when two parties engage in an exchange of financial instruments. A financial instrument is a term often used to refer to tradable monetary assets that may include cash, contractual right to receive cash, or evidence of ownership of a certain asset.
Swaps are essentially a derivative contract in which the value of the contract depends on the assets it represents. These assets are called the underlying assets and their value typically changes, resulting in a change of the value of the derivative itself.
A swap between two parties may be based on interest rates, cash flows, derivatives, bonds, or stocks. However, the assets themselves are not exchanged, but rather their cash flows. Each cash flow is one leg of the swap.
Common types of swaps
Perhaps the most common type of swap is an interest rate swap. Depending on where each party stands financially, an interest swap can be seen as a means to hedge risk or to make more money by speculation. An interest rate swap becomes very useful for companies that are not doing great financially and would like to secure their current status against interest rate fluctuations.
Company A and Company B in talks for an interest rate swap. Company A is suffering financially and has a low credit rating. Consequently, banks are more likely to lend it out money with a relatively high and variable interest rate. On the other hand, Company B is doing financially well and banks are more likely to give out money with a lower and fixed interest rate.
Company A would like to hedge the risk of having interest rates increasing and would prefer to deal with a fixed interest rate even if it’s not necessarily on the low end. On the other side, Company B speculates that interest rates are going to drop during the term of the loan, and that there is a chance for them to save more money.
Assuming both companies have borrowed an equal amount of money, they engage in an interest rate swap, in which Company A gets to secure itself against increasing interest rates while Company B takes the risk of speculating a decreasing interest rate during the term of the loan.
What is an equity swap?
An equity swap is a process in which two cash flows are exchanged between two parties, of which one represents the returns on a stock or stock index. The other leg of the swap represents cash flow from a floating money market index or a fixed rate. However, this is not the only case. An equity swap may also be conducted when both cash flows are from a stock or a stock index.
What are other types of swaps?
Swaps are not only limited to the two mentioned above however popular they are. Other types of swaps include:
Commodity Swaps: which also depend on the value of the underlying commodity and are popular in the oil industry.
Currency Swaps: in which the principal and interest rate of a loan in one currency is exchanges for the principal and the interest rate of a loan in another currency. This is often used by companies to get relatively lower interest rates on foreign currencies than their own or other favorable currencies.
Debt/Equity Swap: in which companies offer their debt holders equity instead of cash. This helps finance projects but is also used when the company fails to pay its debt holders.