Swap

A swap is a contract in which two parties exchange cash flows on different terms. The most common form exchanges fixed interest payments for floating ones.

They exist because each party has different advantages. If one can borrow cheaply at a fixed rate and the other does better on floating, each borrows where it is strong and swaps — and both gain.

They are also used to manage risk. A company with floating-rate debt worried about rising rates can swap into fixed and lock its interest cost.

Currency swaps are widely used too. These exchange principal and interest in different currencies, and between countries they serve as a safety mechanism for securing foreign currency in a crisis.

The danger is the counterparty failing to perform. In the 2008 crisis, collapsing counterparties on derivative contracts spread shock through the system, after which rules requiring central clearing were tightened. Individuals rarely use swaps directly, but it is worth knowing whether a fund or ETF you hold relies on them. Some products replicate returns through swaps rather than holding the assets.