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What is a Swap?

There are various ways to describe swaps in financial terms. The 2 most discussed are Currency Swap and Debt/Equity Swap.

Currency swaps are agreements between two individuals or entities to exchange specified types and amounts of currencies. Along with the initial exchange of a specific amount of one currency for a specific amount of a different currency, the process of a currency swap normally also includes a series of recurring payments based on the cash flow performance of the two currencies. This makes a currency swap somewhat different from a currency exchange, in that the exchange normally involves simply exchanging currency at the most recent rate of exchange.

One important aspect of the currency swap that also sets it apart from currency exchanges is the fact that the swapping of the currency is not a permanent component. At the time that the two currencies are swapped, the parties agree to make the recurring interest rate payments for a specific period of time. Once the duration outlined in the agreement is complete, the two currencies are returned to the original owner. However, each party retains all returns that were shared in the form of interest payments.

As for Debt/Equity Swaps, occasionally, a company may need to undergo some financial restructuring to better position itself for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is canceled for the newly acquired asset class.