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Definition of Swap derivatives:

A swap is
a derivative in
which
two counterparties exchange cash flows of one party's financial
instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments
involved. For example, in the case of a swap involving two bonds,
the benefits in question can be the periodic interest (coupon)
payments associated with such bonds. Specifically, two
counterparties agree to exchange one stream of cash
flows against another stream. The swap agreement defines the
dates when the cash flows are to be paid and the way they
are accrued and calculated. Usually at the time when the contract
is initiated, at least one of these series of cash flows is
determined by an uncertain variable such as a floating interest
rate, foreign exchange rate, equity price, or commodity price.
History of Swap:
The worlds monetary leaders suspended the Bretton
Woods agreement in 1971.
The Chicago Mercantile Exchange introduced foreign
currency futures contracts in 1972.
Salomon Brothers brokered the first currency swap in
1981.
Interest rate swaps first developed in late 1981 Sallie
Mae engaging in the first contract in 1982.
Establishment of the International Swaps and
Derivatives Association (ISDA) and ISDA associated with
most swaps as master agreements since 1985.
CURRENCY SWAP:
A currency swap (or a cross currency swap) is a foreign
exchange derivative between two institutions to exchange
the principal and/or interest payments of a loan in one currency
for equivalent amounts, in net present value terms, in another
currency. A currency swap should be distinguished from interest
rate swap, for in currency swap, both principal and interest of

loan is exchanged from one party to another party for mutual

benefits.
Example:
Party A pays a fixed rate on one currency, Party B pays a fixed
rate
on
another
currency.
Consider a U.S. company (Party A) that is looking to open up a
plant in Germany where its borrowing costs are higher in Europe
than at home. Assuming a 0.6 Euro/USD exchange rate, the U.S.
Company needs 3 million euros to complete an expansion project
in Germany. The company can borrow 3 million euros at 8% in
Europe, or $5 million at 7% in the U.S. The company borrows the
$5 million at 7%, and then enters into a swap to convert the
dollar loan into euros. The counterparty of the swap may likely be
a German company that requires $5 million in U.S. funds.
Likewise, the German company will be able to attain a cheaper
borrowing rate domestically than abroad let's say that the
Germans can borrow at 6% within from banks within the country's
borders.
Let's take a look at the physical payments made using this swap
agreement. At the outset of the contract, the German company
gives the U.S. Company 3 million euros needed to fund the
project, and in exchange for the 3 million euros, US pays $5
million.
Interest Rate Swap:
An agreement between two parties (known as counterparties)
where one stream of future interest payments is exchanged for
another based on a specified principal amount. Interest rate
swaps often exchange a fixed payment for a floating payment
that is linked to an interest rate (most often the LIBOR). A
company will typically use interest rate swaps to limit or manage
exposure to fluctuations in interest rates, or to obtain a
marginally lower interest rate than it would have been able to get
without the swap.

The theory is that one party gets to hedge the risk associated
with their security offering a floating interest rate, while the other
can take advantage of the potential reward while holding
a more conservative asset. Its a win-win situation, but its also a
zero-sum game. The gain one party receives through the swap
will be equal to the loss of the other party. While youre
neutralizing your risk, in a way, one of you is going to lose some
money
Example:
For
example,
assume
that
Ahmed
owns
a
$1,000,000 investment that
pays
him LIBOR +
1%
every
month. As LIBOR goes up and down, the payment Ahmed receives
changes.
Now
assume
that
Sarah
owns
a
$1,000,000 investment that pays her 1.5% every month.
The payments he receives never changes. Ahmed decides that he
would rather lock in a constant payment and Sarah decides that
she'd rather take a chance on receiving higher payments. So
Ahmed and Sarah agree to enter into an interest
rate swap contract. Under the terms of their contract, Ahmed
agrees to pay Sarah LIBOR + 1% per month on a
$1,000,000principal amount. Sarah agrees to pay Charlie 1.5%
per month on the $1,000,000 notional amount.
Interest rate swaps are traded over the counter, and if your
company decides to exchange interest rates, you and the other
party will need to agree on two main issues:
1. Length of the swap. Establish a start date and a maturity
date for the swap, and know that both parties will be bound
to all of the terms of the agreement until the contract
expires.
2. Terms of the swap. Be clear about the terms under which
youre exchanging interest rates. Youll need to carefully
weigh the required frequency of payments (annually,
quarterly, or monthly).