Meaning and definition of swap
Customarily, swap is delineated as the exchange of one security for another to alter the quality of issues (stocks or bonds), maturity (bonds), or because of change in investment objectives. In recent times, swaps have grown to take account of currency swaps and interest rate swaps.
As explained by Investopedia, if firms in different countries feature comparative interest rates or advantages, then a swap could be beneficial for both the companies/firms. For instance, one firm features a lower fixed interest rate, while another features a lower floating interest rate. These firms could swap to benefit from the lower rates.
In finance, particularly, a swap refers to a derivative which involves counterparties to exchange certain benefits of the financial instruments of one party for those of the other.
Types of swaps
The five common types of swaps include:
- Interest rate swaps
This swap type involves the exchange of fixed rate loan to a floating rate loan and vice versa. The life of this swap vitiates 2-15 years. The main reason for occurrence of this swap is taking advantage from comparative advantage.
- Commodity swaps
A commodity swap can be explained as an agreement which involves a floating price being exchanged for a fixed price over a certain period of time.
- Credit swaps
This is a swap contract wherein the buyer makes numerous installments of payments to the seller thus receiving a payoff if an instrument (specifically a loan or bond) goes into default. Less frequently, the credit event responsible for triggering the payoff can include a company going through bankruptcy, restructuring, or even just experiencing a downgrade in credit rating.
- Currency swaps
A currency swap is the one in which principal and fixed rate interest payments on a loan in one currency are exchanged for the same in another currency. Akin to interest rate swaps, the currency swaps are also influenced by comparative advantage.
- Equity swaps
This swap is a special type of swap based on total return, wherein the underlying asset includes a stock, stock index, or a stock basket. Contrasted to actually owning the stock, this swap does not require any payment to be made up front, but you also do not possess voting or any other rights like other stock holders.