Template:Swap - layman

A swap pioneer from the 1970s

Swaps 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 we do that?

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 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.

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 derivatives called credit default swaps

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.