SWAP

A swap is an agreement between two counterparties to exchange two streams of cash flows—the parties "swap" the cash flow streams. Those cash flow streams can be defined in almost any manner. All that matters is that their present values be equal. Their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability.

 When a swap is first entered into, it has zero market value. This is because both cash flow streams have identical, offsetting market values. As time goes by, the swap is likely to take on a positive or negative market value. This may happen for one or two reasons:

Market variables that affect the market values of one or both cash flow streams will fluctuate, causing the values of the cash flow streams to change.

One cash flow stream may have more accelerated payments than the other, so the swap takes on a positive market value for the party making the more accelerated payments. An extreme case of this is some customized swaps that require one party to make a substantial payment right at the outset.

A swap is a cash-settled OTC derivative under which two counterparties exchange two streams of cash flows. It is called an interest rate swap if both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations.

The most popular interest rate swaps are fixed-for-floating swaps under which cash flows of a fixed rate loan are exchanged for those of a floating rate loan.