Swaps 

are derivative instruments that represent an agreement between two parties to exchange a

series of cash flows over a specific period of time.

Swaps offer great flexibility in designing and structuring contracts based on mutual agreement.

This flexibility generates many swap variations, with each serving a specific purpose.

There are multiple reasons why parties agree to such an exchange:

 Investment objectives or repayment scenarios may have changed.

 There may be increased financial benefit in switching to newly available or alternative cash
flow streams.
 The need may arise to hedge or mitigate risk associated with a floating rate loan repayment

Eg.
Assume Paul prefers a fixed rate loan and has loans available at a floating rate
(LIBOR+0.5%) or at a fixed rate (10.75%).
Mary prefers a floating rate loan and has loans available at a floating rate (LIBOR+0.25%) or
at a fixed rate (10%).
Due to a better credit rating, Mary has the advantage over Paul in both the floating rate
market (by 0.25%) and in the fixed rate market (by 0.75%).
Her advantage is greater in the fixed rate market so she picks up the fixed rate loan.
However, since she prefers the floating rate, she gets into a swap contract with a bank to
pay LIBOR and receive a 10% fixed rate.
Paul borrows at floating (LIBOR+0.5%), but since he prefers fixed, he enters into a swap
contract with the bank to pay fixed 10.10% and receive the floating rate. 

Fixe
  d Floating  
he enters
into a
swap
contract
with the
bank to
pay fixed
10.10%
and
receive the
Pau 10.7 Libor+0.5 floating
l 5 % rate. 
she gets
into a swap
contract
with a bank
to
pay LIBOR a Benefits:
Paul pays (LIBOR+0.5%) to the lender and 10.10% to the
nd receive a
bank, and receives LIBOR from the bank. His net payment is
Mar Libor+0.2 10% fixed
10.6% (fixed). The swap effectively converted his original
y 10% 5% rate. floating payment to a fixed rate, getting him the most
economical rate.

Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. Her
net payment is LIBOR (floating). The swap effectively converted her original fixed payment to the
desired floating, getting her the most economical rate.

The bank takes a cut of 0.10% from what it receives from Paul and pays to Mary.