Swap

Swaps are financial instruments that involve an exchange of cash flows between two parties on an underlying amount.

A swap agreement may involve a party with a fixed cash flow that wants to switch to a variable cash flow with another party which has a variable cash flow and want to switch to a fixed cash flow. An interest rate swap is an example of a swap agreement in which one part who borrows at a fixed rate (eg fixed interest rate for 5 years) may wish to change the interest flow with another part who borrows at a variable interest rate. The reason for the change may be that the parts have different credit ratings and thus different terms for fixed rate and variable rate, which means that both parties will benefit from an exchange of interest payments rather than to subscribe directly for loans at fixed and variable rates.

Reasons to use interest rate swaps can be to:
+ achieve changes in repricing periods
+ redistribute the interest rate structure of the balance sheet
+ a company expects declining or rising interest rates
+ a company wants to match the interest flows between assets and liabilities
+ a company wants fixed interest rate for planning purposes
+ a company wants to change the currency exposure for interest payments

If two parties enter into a interest swap agreement it might be as follows. A company (Cape Ltd) that has a fixed interest rate on its loan wants to change to a variable interest rate becuase they expects falling interest rates. A swap agreement is signed with another part (Conc Ltd), which has a variable interest rate. Cape Ltd who have a fixed rate loan pays a fixed interest rate on its loan to the bank and receives a fixed interest payment from Conc Ltd. Conc Ltd who have a variable rate loan pays variable interest on its loan to the bank and receives variable interest rate from Cape Ltd. This swap agreement means that the parties have changed variable and fixed cash flow between each other.

Banks acts as market makers for swaps, companies that want to enter into swap agreements may apply to the bank and have the bank as a counterparty in a swap agreement.