Swaps Contract – Meaning & Evolution
1. Introduction
A Swap is one of the most popular derivatives for large corporations and banks. As the name suggests, it involves "Swapping" or exchanging something. It allows two parties to exchange their liabilities (interest payments) or assets (cash flows) to benefit each other.
2. Definition
"A Swap is a private agreement between two parties to exchange cash flows at specified intervals based on a specified principle amount."
- Key Feature: Unlike Futures/Options, Swaps are usually OTC (Over The Counter) instruments. They are customized between banks.
- Principle: They are not usually traded on exchanges (though Swaptions exist).
3. Why do Swaps exist? (Comparative Advantage)
The economic logic behind swaps is the Theory of Comparative Advantage.
- Scenario: Company A has a good credit rating in the USA. Company B has a good rating in Japan.
- Problem: Company A wants to borrow yen (Japan), and Company B wants to borrow dollars (USA).
- Solution: Instead of borrowing directly in foreign markets (where they are unknown and charged high rates), they borrow in their home markets (cheaply) and then Swap the loans. Both save money!
4. Exam Notes: Writing the Answer
Question: "Define Swaps. Why are they popular?" (5 Marks)
Answering Structure:
- Definition: "Agreement to exchange cash flows...".
- Nature: Mention "OTC Instrument".
- Rationale: Explain "Comparative Advantage" – borrowing where you are strong and swapping for what you need.
5. Quiz Time! 🎯
Loading quiz…