Meaning of Swaps
Swap literally means exchange. It refers to exchange a thing in return for another it is an agreement between two parties to exchange a series of cash flows over a period in the future. Swap is an agreement to exchange one stream of cash flow for another in future. These two streams of cash flows may be called two legs of a swap contract. The basic idea behind swaps is that the parties involved get access to markets at better terms than would be available to each one of them individually. The gains achieved by the parties are divided amongst them depending on their relative competitive advantage.
Financial swap is a specific fund technique which permits a borrower to access one e market and then exchange the liability for another type of liability. Thus, under a swap contract future cash flows are traded over a period of time. In short, swap is an agreement between two parties in order to trade future cash flows.
Terms Used In Swap Contract
- Parties : Generally, there are two parties in a swap deal. Intermediaries are excluded. For example, in an interest rate swap, the first party can be a fixed rate payer / receiverand the second party can be a floating rate receiver / payer. The parties to the swap contract are known as counter-parties.
- Swap facilitators : A swap facilitator is a mediator who assists in formation and completion of a swap arrangement between the interested parties. A swap facilitator is generally a bank. There are two kinds of swap facilitators – Swap broker and swap dealer. (a) Swap Broker : A swap broker is an intermediary. He is an economic agent. He helps in identifying the potential counter parties in a swap deal. He acts only as a facilitator. He does not take any individual position in the swap contract. He will charge commission for his services. (b) Swap Dealer : Aswap dealer associates himself with the swap deal. He often becomes an actual party to the transaction. He may be actively involved as a financial intermediary for earning a profit. He is also known as market maker.
- Notional Principal : Notional principal is the underlying amount in a swap contract Thisunderlying amount becomes the basis for the deal between counterparties. It is called “notional” because this amount does not vary, but the cash flows in the swap are attached to this amount. For example, in an interest rate swap, the interest is calculated on the notional principal.
- Trade date : Trade date is the date on which both the parties in a swap deal enter into the contract.
- Effective date : This is the date when the initial cash flows in a swap contract begin. The maturity of swap contract is calculated from this date. Effective date is also known as value date.
- Reset Date : This is the date on which the LIBOR rate is determined. The first next date will be generally two days before the second payment date and so on.
- Maturity date : This is the date on which the outstanding cash flows stop in the swap contract.
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