Swaps

Swaps constitute a financial instrument in accordance with which two parties agree to give flows of cash or other financial instruments of one another for the period of the time they have been specified. These can be employed especially for managing interest rate dangers, currency fluctuations, or even speculating in terms of changing the prices of commodities in the market.

Features

• These swaps call for a trade of cash flows or different types of financial instruments (e.g., bonds) which must comply with the detailed arrangements and conditions established earlier.
• Ordinary swaps categorized as interest rate swaps, currency swaps, and commodity swaps are among the commons ones.
• Such as interest rate swaps, the former somehow involves changing floating interest rate payments for fixed interest rate payments and vise versa depending on the context.
• The process of a modern currency swaps is the conversion of the main amount and the interest payments from one currency to another.
• This can be done by including terms like the principal amount, when and how frequent payments are made, and dates of payment maturity.

Advantages

• Risk Management: Swaps can be defined as a means for rebalancing or transferring certain risks meaning that they fit the interests of participants, regarding interest rate risk and currency risk, and allow to mitigate the influence of unfavourable factors.
• Cost Efficiency: Swaps, moreover, could be great ways to get lower cost entrance to some markets or specific financial objectives, for example, without a need to have ownership of the assets.
• Customization: The flexibility of swaps as an option of customizable contracts gives parties the authority to customize the contract to their demands, yet still enhance their directing of risk management or investment.

Disadvantages

• Counterparty Risk: The swaps agreement can be considered as a counter party risk from the perspective of the parties being exposed to the risk that the other party may fail to timely perform its obligations.
• Complexity: Swaps are in fact financial products that are very complex and therefore a deep immersion into the markets, valuation methods, and legal papers is required.
• Market Risk: Swaps are exchange of one payment stream for another which may either be fixed or floating. Changes in market conditions, like interest rates or currency exchange rates, can impact the value of a swap and may incur losses for the parties involved.

Examples

• The company could use an interest rate swap in which the company with a variable rate loan of about 5% interest rate swaps payments with another party who owns a fixed rate loan interest rate of about 8% and this would help reduce interest rate exposure.
• One example of currency swap could be the arrangement between two multinational corporations to exchange cash flows generated in difference currencies instead of constantly resisting against the exchange rate risks in foreign transactions.
• An effective approach of commodity swap in which agreement has been reached by a producer to sell his/her commodity at a fixed price to a financial entity in return for its finance the variable market prices, this creates a more stable revenue.