A swap is a derivative that involves two counterparties agreeing to exchange (swap) a series of future cash flow streams to which they are entitled by virtue of their ownership of particular securities (for example, the interest payments to which they are entitled by virtue of their ownership of bonds).
Typically, the value of one series of cash flow streams involved in the swap is uncertain at the outset. Its value could for instance change in line with macroeconomic changes or developments in the market. For example, the value of one cash flow stream being swapped may be linked to: the change in price of shares or a change in the amount of the dividends paid to holders of the shares (an equity swap) or a floating interest rate (an interest rate swap).
Through enabling parties that are due to receive uncertain amounts of money to trade in the uncertainty for fixed payments, swaps facilitate more accurate budgeting through enabling parties to fix the value of future cash flows that they are due to receive. This can also help parties to mitigate (hedge against) the risk of receiving less money than expected if the market moves adversely. Conversely, parties entitled to a stream of cash flows with a fixed value may wish to speculate, trading in the right to receive payments of a predetermined value in the belief that the market may move in a manner that will result in them receiving cash flows that exceed the value of the fixed cash flows to which they would otherwise have been entitled.
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By Jake Schogger - City Career Series