Swaps are over-the-counter contracts whose terms are customized to the specific needs of both parties. They are a popular form of derivative investment, particularly among financial institutions and firms. In general, swap instruments are not interest payments, but they can include commodities, currencies, or debts. Some types of swaps are currency swaps, debt swaps, total return options. Traders who are new to the world of derivatives may be wondering: how are they traded?
In essence, swaps are similar to derivatives in that cash flows in a swap contract are determined by a certain variable. This variable could be a foreign exchange rate, an interest rate, an equity, or a commodity price. As such, a single firm might issue bonds with variable rates, and another firm would buy those bonds for a fixed rate. When rates rise, the former would benefit, while the latter would lose.
When banks issue bonds, they often seek a partner to pay the interest on the bonds. The firm would then look for another firm to pay the interest on the bond. Alternatively, it could request a fixed interest rate on a fixed amount of money. As long as the interest rate fluctuates, both firms would benefit. This is a basic example of how swaps work. The payment frequency is determined by the two parties.