Swap Funds

• In finance, a swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.


• Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement

Types of Swaps 

Interest Rate Swap

• The most common type of swap is a “plain Vanilla” interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage.


• Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets.


• A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.


• In this only INTEREST on predetermined principal at predetermined rate (variable or fixed) is exchanged / swap.


• For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%.

Currency Swaps

• A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.


• Just like interest rate swaps, the currency swaps are also motivated by comparative advantage.


• Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

Credit Default Swaps

• A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if an instrument, typically a bond or loan, goes into default (fails to pay).


• Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded.


• CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.