Swaps. A swap is a type of forward contract represented by a contractual obligation, arranged by an intermediary that requires the exchange of cash flows between two parties. Swaps are customized to meet the needs of the specific parties and are not traded on regulated exchanges.
Most often swaps are used to hedge against unfavorable outcomes and are explained more fully in the later discussion of hedging. However, it is important to understand the basic format of a swap. Common examples include foreign currency swaps and interest rate swaps.
For example, assume a U.S. company has an opportunity to invest in a German joint venture that is expected to last six months.The U.S. company must invest German marks in the venture, and its investment will be returned in German marks at the end of the 6-month period. Through an intermediary, the U.S. company could contract with a German company that needs U.S. dollars for a similar period of time. Each of the companies would have available or borrow their respective currencies and then swap the currencies, dollars for marks and marks for dollars. At the end of the 6-month investment period, the U.S. company would return marks to the German company, and the German company would
return dollars to the U.S. company.
return dollars to the U.S. company.