Swap - a simple Introduction
If two parties make an agreement to exchange sequences of funds flows for a pre-determined period of time which is called a swap. In general, when the contract is initiated, at least one of these series of funds flows is controlled by a rather uncertain variable. This variable might be foreign exchange rate, interest rate, commodity price or equity price. For a few traders, a swap is nothing but a portfolio of forward contracts. Whereas, some define it as a long position in a specific bond that's coupled with Yet another bond's short position. You will find two distinct kinds of swaps in existence such as plain vanilla foreign currency swaps and plain vanilla interest rate swaps.

Remember that swaps usually are not exchange traded instruments, unlike essentially the most futures contracts or standardized options. Swaps can rather be defined as customized contracts which could be traded inside the over the counter market between the private parties. Mostly, financial institutions and firms dominate the swaps market, whereas, in some cases, sure individuals participate within the same. As the swaps operate typically on the over the counter market, the risk of a counterparty defaulting on the swap is constantly there.

Let's take a dive into history now. In 1981, for the first time ever, interest rate forex swap happened between the World Bank and IBM. simply because then, despite the shorter time frame of its existence, swaps have exploded in popularity. In 1987, in a report published by the International Swaps and Derivatives Association, the total notional value of the swaps industry was of $865.6 billion. This figure went past $250 trillion by end of 2006, as far as the reports of the Bank of International Settlements. This is in reality much more than 15 times of the total size of the public equities industry of US.

Plain Vanilla Interest Rate Swaps

In this case, one party agrees to pay the other party a predetermined, fixed rate of interest on a notion principal on several specific dates for a predetermined time period. in the same time, the other party will need to pay very first party on a specific floating rate on the same concept principal on the same specified dates and time period. In less complicated words, for plain vanilla interest rate swaps, each of the dollars flows are paid inside the very same currency.

Plain Vanilla Foreign Currency Swaps

In this case, the parties participating within the currency swap have to exchange principal amounts right in the beginning and too after the swap ends. The currencies are different: however, the amount is set in a way so that the total worth is equal for both the parties.