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Swaps

Updated on May 29, 2013

Since 1981 the most dynamically developing derivatives are swaps. Swap contracts are created when the contracting parties agree to the exchange of their future cash flows (based on the value of a predefined, specified basic product). These exchanging contracts are called “swaps”. These swaps are portfolios of forward contracts. The initial and final value of swaps is zero. The cash flows constituting the swaps are based on interest rates. In the most basic cases, which are simple interests swaps, one of the parties pays preset amounts of cash to the other contracting party. The amount of each payment is determined by the interest rate and face value. In exchange, the other party, the one which receives the payments, agree, pays an amount in the same currency with the same face value, but, its size is dependant on floating interest rates. In other words, interest swaps change floating interest rate to fixed interest rates and vice versa. The most often used floating interest rates during interest rate swap contracts is the LIBOR (London Interbank Offer Rate). The LIBOR determines the interest rate that banks use in the Euro FX markets, and have either 1-, 3-, or 6 months maturity periods. LIBOR are reference on international markets; a 3 month LIBOR is the basis on EUR/USD futures contracts.

There are many types of swaps, however the most widely used ones are the currency swaps. During currency swap contracts, the installments of fixed interest credits issued in different currencies are exchanged.

Source

Financial Markets vol. I. Functioning of Financial Markets

Beata Majer, Julia Kiraly

International Banker Training Center LLC.

Budapest, Hungary

2000

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