Swaps can be defined as a derivate contact composed of two parties that exchange to cash flow between two separate financial instruments.
They are generally divided into two categories. This includes contingent claims (options) and forward claims, where forward contracts, swaps, and exchange-traded funds (ETFs) are exchanged.
Commodity price, equity price, interest rate, and foreign exchange rate are common variables used as one of the cash flows in swaps upon initiation.
Different Types of Swaps
Common types of swaps include interest rate swaps, commodity swaps, currency swaps, and debt-equity swaps.
Interest rate swaps are used to hedge against interest rate risk and involve cash flows exchanged between two parties that are comprised of a notional principal amount.
A financial intermediary or a bank is used for swaps but these are dependent upon both party’s comparative advantage.
Commodity swaps use the exchange of a floating commodity price, with a predetermined set price for a specific period while crude oil is the most heavily swapped commodity.
Meanwhile, currency swaps involve the exchange of principal payments of debt and interest that are denominated in different currencies.
An example of a currency swap would be when the U.S. Federal Reserve conducted a swap with central banks of Europe during the 2010 European financial crisis.
Used as a way to reallocate capital structure or refinance debt, a debt-equity swap deals with the exchange of debt for equity. For instance, a public traded company would issue bonds for stocks.
Swaps are not exchange-traded instruments but rather customized contracts traded in an over-the-counter market between parties.
While the swaps industry is primarily used by firms and financial institutions, retail traders have been known to participate although there is always a risk of counterparty’s defaulting on agreed-upon swaps.