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8 - Swaps – Part I: Interest Rate and Currency Swaps

from Part–III - Swaps

Published online by Cambridge University Press:  02 August 2019

T. V. Somanathan
Affiliation:
Government of India
V. Anantha Nageswaran
Affiliation:
Singapore Management University
Harsh Gupta
Affiliation:
Bain and Company
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Summary

Swaps are contracts in which two separate streams of cash flow are exchanged or ‘swapped’. The streams could be two different kinds of interest amounts, two currencies or indeed any two differing streams of cash.

This chapter introduces the conceptual basis of swap contracts and then explains interest rate swaps and currency swaps. The next chapter deals with other types of swaps and some general issues relating to the swaps market.

Definition

A swap transaction is a contract by which two or more parties exchange (swap) one set of pre-determined payments for another.

Some important types of swap are the following:

  • An interest rate swap is an agreement between two parties to exchange interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period.

  • A currency swap is an agreement between two parties to exchange payments or receipts in one currency for payments or receipts in another.

  • An equity swap is an agreement between two parties to exchange dividends and/or capital returns on an underlying share with another equity flow or interest flow, in the same or different currencies.

  • Currency swaps slightly predated interest rate swaps, but the latter now predominate in volume. Equity swaps are more recent but growing fast. Swaps can also combine some of the features of interest rate and, say, currency swaps. Thus, a fixed rate payment in dollars might be swapped for a floating rate payment in yen. Such transactions are more complex.

    A key feature of swaps is that they deal with a set of cash flows involving multiple periods, not a one-time cash flow. This is an important distinction between swaps and futures or options, both of which deal with a single expected cash flow at one specified time in the future. In a swap, invariably there are multiple dates involved where one or more income streams would need to exchange hands. Sometimes the two cash flows are paid gross to each other, while in some cases, the amount due is ‘netted’ and the net amount due from one party to another is transferred.

    Type
    Chapter
    Information
    Derivatives
    , pp. 135 - 142
    Publisher: Cambridge University Press
    Print publication year: 2017

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