Swaps

A swap involves an agreement between two parties to exchange cash flows, without exchanging the underlying asset itself. It's classified as a derivative contract because its value is derived from the performance of this underlying asset, index, or financial variable—namely interest rates, currencies, or commodities.

In a swap agreement, each party agrees to make periodic payments based on certain variables. These cash flows are determined by the contract terms and can be based on factors such as:

1. Interest rates: One party may agree to pay a fixed interest rate (for example, 5%) on a notional amount, while the other party pays a floating rate (e.g., LIBOR) that fluctuates over time. This is common in interest rate swaps.
2. Currencies: In a currency swap, one party might agree to pay in a specific currency (e.g., USD), while the other pays in another currency (e.g., EUR). The exchange rate is predetermined and fixed in the contract.
3. Commodities: Commodity swaps involve exchanging cash flows based on the price of a commodity. For example, one party might pay based on the price of oil, while the other party pays according to a fixed or floating price of the same commodity.

Swaps are typically traded over-the-counter (OTC), meaning they are not standardized or traded on an exchange, but are privately negotiated between the two parties. This makes swaps customizable, allowing participants to tailor contracts to their specific needs. However, to reduce counterparty risk, many swaps are cleared through centralized clearinghouses like CME ClearPort, which ensures that both parties can meet their obligations and increases market transparency.

Swaps are commonly used for hedging against interest rate risk, currency fluctuations, or commodity price changes, and for speculation on these factors. They are also valuable for arbitrage opportunities, where traders exploit price differences between markets or financial instruments.