In financial term, Swap is a special type of derivative through which one party can swap some financial benefit with other party in exchange of other’s financial benefit so that both the parties can gain the maximum out of the deal. The financial benefit of the swap transaction depends on the type of financial investment or instrument they are using.
Suppose foreign loan is available only at floating rate of interest. For the borrower the financial benefit can be a favorable fixed exchange rate on the foreign money borrowed and for another party (let’s assume a bank) the financial benefit can be floating exchange rate. Here the borrower can swap the interest payment with the bank such that he can do the interest payment only in fixed rate and the bank will pay the floating rate of interest. Here both the parties will get the financial benefit through Swap.
Swaps are also very well known derivative instrument used for hedging different risks such as interest rate risk, exchange rate risk or commodity price risk.
Different types of Swaps are used for different financial benefits. The main types are