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[[File:Noel.png|thumb|A swap pioneer from the 1970s]] | [[File:Noel.png|thumb|A swap pioneer from the 1970s]] | ||
{{tag|Swap}}s come in all shapes and sizes, but at their heart they are | {{tag|Swap}}s come in all shapes and sizes, but at their heart they are agreements to exchange — “swap” — payment streams. In the simplest example, you and I could agree, for a period of 5 years, that I will pay you a fixed interest rate calculated on an agreed sum, and you will pay me a floating rate calculated on that same sum. We don't pay the actual sum itself. | ||
Why would | Why would we do that? | ||
Well, imagine you had | Well, imagine you had source of [[floating rate]] income (for example, a [[floating rate note]]), but you had a fixed rate liability (say your mortgage). | ||
Finding a [[swap counterparty]] to swap]] your [[floating rate]] income | Finding a [[swap counterparty]] to [[swap]] your [[floating rate]] income into a [[fixed rate]] means you will be able to meet your mortgage payments from the [[floating rate note]] income without having to worry about what happens if floating interest rates fall. | ||
Used in this way, | This means you give up the benefit of rising interest rates on your [[floating rate note]], but it also means you are protected from losses if interest rates fall. Used in this way, a [[swap]] is a form of [[insurance]]. Bankers call this kind of insurance a [[hedge]]. | ||
You can enter a swap even if you don't own a source of income paying you the rate you are swapping away. Bankers have all kinds of imaginative names for this kind of activity: [[pre-hedging]]; seeking [[alpha]]; yield-enhancing, but you will know it as [[gambling]]. Warren Buffett calls swaps financial weapoms of mass destruction. This is a bit of hyperbole, but he still felt pretty smug when the world nearly blew up in 2008 because of complex [[Derivative|derivatives]] called [[credit default swap]]s | |||
You can swap all kinds of cashflows - not just interest rates. Cashflows can be derived from any financial asset: bonds, [[shares]], [[commodities]], and even repacjaged cashflows on sub-prime mortgages<ref>Don’t do this. I mean, really, don’t.</ref>. |