Template:Swap - layman: Difference between revisions

[[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 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 rate on an agreed sum, and you will pay me a floating rate on the same sum. We don't pay the actual sum itself.

Why would we do exchange those cashflows then?

Imagine you had a [[floating rate]] income (for example, a [[floating rate note]]), but you had a fixed rate liability (say a mortgage).

By [[swap]]ping your [[floating rate]] income into a [[fixed rate]] you will can meet your mortgage payments without having to worry about interest rates falling on your [[note]]. On the other hand, you give up the profit if interest rates ''rise'' on your [[note]].  

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 repackaged cashflows on sub-prime mortgages<ref>Don’t do this. I mean, really, don’t.</ref>.