Introduction
A swap is a contract which is based on a derivative by which two parties are allowed to exchange their cash flows and liabilities from more than one fiscal instruments. Majority of the swaps consists of cash flows that are obtained on the basis of a notional principal amount like bond or loan.
These instruments can be anything. Generally, the principal is not going to move between multiple hands. One cash flow is typically fixed, and the other is going to vary on the basis of the interest rate of a benchmark, index price, or floating currency exchange rate.
Types of Swap
Interest Swaps
The interest swap is the most commonly used kind of swap. You need to know that swaps are not traded on the exchanges. Also, retail investors are typically not involved in swaps. Instead, swaps are the contracts that are of over-the-counter nature and are basically performed among financial institutions or businesses, designed as per the needs of the parties involved.
Currency Swaps
In currency swaps, the parties will go onto exchange principal payments and interest on debt denominated in various currencies. Dissimilar to swapping interest rate, the notional amount is not the principal.
Instead, it is exchanged with the obligations of interest. Currency swaps may also happen between nations. For instance, Argentina and China are involved in swaps of currencies, and this has helped Argentina in steadying its foreign exchange reserves.
The United States Federal Reserve was involved in intensive currency swap strategy with the central banks of the European region back in the year 2010. This was done with the view of stabilising the currency euro, which was severed due to the financial crisis induced by the debt crisis in Greece.
