A Swap refers to a particular derivative contract. They allow for two opposite parties to exchange certain types of financial instruments as the name quite literally implies. While in theory the instruments involved in such an exchange could be practically anything, in reality the majority of them prove to deal with cash flows on a principal amount with which the two entities concur.
In general, the underlying principal will not be exchanged in the arrangement. The two cash flows each instead make up a single leg of the swap contract. The one will usually be variable while the other one is fixed. The variable one is generally based on an agreed upon benchmark interest rate, index price, or alternatively free-floating currency exchange rate.
These swaps never trade over exchanges. This prevents retail investors from becoming involved in them. Instead, these instruments prove to be specially traded over the counter contracts between financial institutions or firms. The most typical form of swaps is the interest rate swap. Other forms include currency, commodity, debt equity, and total return.
Interest rate swaps involve the participants changing out cash flows for the underlying rates based upon the idea of a principal amount. They do this to speculate or to hedge against the possibility of interest rates rising or falling. It is always illuminating to consider a real world example to better understand a difficult concept like this one. International British based banking giant HSBC may have recently issued out $5 million in five year maturity bonds that come with a yearly interest rate based upon the LIBOR London Interbank Offered Rate plus 1.5 percent. While the LIBOR rate remains at 1.8 percent, this would be low for the historical average range. HSBC would be nervous about the possibilities of the rates climbing.
To offset said risk, HSBC engages with Deutsche Bank in order to receive the annual LIBOR plus 1.5 percent on the principal. So Deutsche Bank will pay the interest payments on the HSBC most recent bond issue. In consideration for this, HSBC pays to Deutsche Bank a fixed yearly six percent interest rate on the same $5 million over the next five years. HSBC gains if the rates increase substantially during the next five years. Deutsche Bank gains advantage if the rates should rise just slightly, remain flat, or decline instead over the five years period. It is important to realize that in the majority of cases, HSBC and Deutsche Bank would work through an intermediary company or other financial institution which would also participate in getting a piece of the swap deal for their trouble. Determining if such swaps make sense for two different companies comes down to the relative comparative advantage in the floating rate or fixed exchange lending markets which each enjoys.
Currency swaps involve the two participants changing principal payments and interest on debt which was originally denominated in other currencies. With these forms of swaps, the principal is not only notional. It is actually changed back and forth along with the interest payments. Entire nations can engage in these currency swaps. As a clear example, China has opened a currency swap with Argentina. This assists Argentina with stabilizing its own foreign reserves as a result. China gains the advantage of their currency being a little bit stronger and more desirable reserve currency as a result.
With commodity swaps, the pair is exchanging a predetermined floating commodity price. This could be the price of Brent Crude spot. They do this for a mutually decided on time frame. The most typically involved commodity swaps actually are for crude oil.
Debt equity swaps revolve around exchanging debt for equity. With publically traded firms, this literally means bonds in exchange for stocks. It helps corporations to effectively refinance their own debt in a far easier and less hassled way than getting approved for financing.
Finally, total return swaps are those which involve changing out a fixed interest rate in return for the total returns off of an asset. The group which will furnish the fixed rate will thus not have to spend its precious capital in order to hold the index or stock which it gets in exchange.