(FINANCE) a type of
financial derivative which two parties "swap," or exchange, the streams of income (or payments) from two different sources. The actual instrument is created by a third party, such as an investment bank.
The most familiar version of the swap is the interest
rate swap, in which the holder of a fixed rate loan and the holder of an adjustable rate loan agree to exchange revenue streams.
The variety of swaps available is massively greater than with options or futures; essentially, swaps exist for every
arbitrage opportunity that any combination of markets provides; the market for swaps is huge.
BILL: Why do
firms buy
swaps? Why don't they just sell the loans they have to other banks, or whatever?
ANNA: One is that swaps are a method of
hedging risk; you hold the bond in case the price goes up, but you buy interest rate swaps to protect against having average rates in your portfolio that are two high or two low.
