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A swap is basically a contract through which facilitates the exchange of financial instruments between two parties. The instruments may be nearly anything, although cash flows are involved in most of the swaps based on notional principal that is agreed to by both the concerned parties. The principal generally doesn’t change hands. Generally, a cash flow is fixed and other one is variable, which is based on exchange rate of floating currency, index price or benchmark interest rate.
Kinds of swap
Your swaps homework answers might require you to state the different kinds of swaps. Swap of interest rate is the most common type of swap. Retail investors usually don’t indulge in swaps and swaps don’t trade on exchanges. Instead, swaps are just contracts between financial institutions or businesses.
The exchange of financial instrument in swaps doesn’t necessarily have to be that of interest payments. There are numerous types of swap agreements. However, the most common of them all are:
With this swap, the principal and interest payments are exchanged between parties on debts in other currencies. In contrast to interest rate swaps, principal isn’t a notional principal amount; rather the exchange even involves interest obligations.
It generally involves floating commodity price exchange for a specific price over a certain period agreed upon.
This involves exchange between debt and equity. For publicly traded companies, this means exchange of bonds and stocks. Companies use such swaps for reallocating their capital structure or refinancing their debt
With this form of swap, there is an exchange of an asset’s total return is for a specific interest rate.
Why use swaps?
This is a common homework question for this topic and it is important to prepare swaps homework answers for it. There are two main categories for the reason to use swap contracts: commercial needs and comparative advantage. Some normal business operations can result in some sort of currency or interest rate exposures that can be alleviated by swaps. Companies may also use for comparative advantage, so that it can then use it for converting it to a desire financing type.
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