What is Swap in Finance

If you have studied finance books in your business school, you have surely studied different swaps like currency swap, credit default swap and interest rate swap. But still, one question is important, what is its definition which you can use for learning other advance concepts of swap.


Definition of Swap 

Swap is the contract of exchange of cash flow by exchanging of one financial instrument into other financial instrument. For example, you have some bonds of a company which have big losses, so, there is big chance of loss in these bonds. This company is still giving to you the interest. So, you have still tax liability. You just go to derivative market and sell this bonds on loss and buy other company's bond which is performing well. This is swap contract. Your are selling your financial instrument and buying other financial instrument by exchanging net cash flow of profit or loss in this transaction. But main aim of saving from big losses. Swap will always in cash contract. It never in future or forward or option contract.




Types of Swap 


1. Currency Swap 

Currency Swap is an agreement between two parties of two countries for exchanging of principle and interest of loan at its present value. This swap is very useful for controlling foreign exchange risk. Interest rate swap is different from currency swap, because in interest rate swap, we just exchange the interest from fixed to floating rates but in currency swap, we both principle and interest of loan is exchanged from one party to another party for mutual benefits. Read more at here


2. Credit Default Swap 

Suppose, I gave $ 10 million loan to A.  This is my asset. If A will become defaulter, what will happen with my $ 10 million investment in the form of loan. It will become Zero. I am also noble personality and I can not quarrel with A. So, I contract with an insurance company and buy credit swap policy. Now, I am tension free. If my borrower will not repay my loan, my $ 10 million loan will be repaid by insurance company. So, like interest rate swap, credit default swap is exchange agreement between insurance company and lender. Insurance company takes the risk of loss due to loan defaulting. Lender will be responsible to pay the amount of CDS policy. Read more at here


3. Interest rate swap

Interest rate swap is contract between two companies through any financial intermediary. This contract is of exchange of  interest rate. In this contract, one company exchanges his fixed interest rate in to floating interest rate and other company exchanges his floating interest rate in to fixed interest rate. This deal is done in international money market or by derivative in OTC market. This is good way to hedge in the fluctuation of interest rates. Main aim of interest rate swap to reduce the cost of debt.   Read more at here


4. Bond Swap 

Bond swap is the exchange of two swap and different between the price will also exchange in net cash flow from one party to other party. One will be the seller of bond. Same time, he will also the buyer of bonds to whom, he is selling his bond. Net difference between the sale price and purchase price will be paid through cash. This contract will be bond swap.


5. Commodity Swap 

Commodity swap is the swap of prices of any commodity. We know that both buyer and seller are not interested to suffer loss due to changes in the market price of commodity. If commodity price will increase, buyer will always cry. If commodity price will decrease, seller will always cry. So, through hedging, we can reduce this risk. Commodity swap is the great tool of hedging of commodity prices. In this swap agreement, buyer and seller lock the price by net cash flow to each other. For example, buyer want to buy at $ 100 per litre petrol and seller want to sell at $ 150 per litre petrol. If both agree to do commodity swap agreement, they agree to lock prices at $ 120 if buyer will pay $ 20 advance to seller. In future, seller will not increase prices whether market will increase the price or not. 

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Accounting Education: What is Swap in Finance
What is Swap in Finance
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