A swap is a contract in which two parties agree to exchange cash flows. For example, one party is currently receiving cash from one investment but would prefer another type of investment in which the cash flows are different. The party goes to a swap dealer, a firm operating in the over-the-counter market, who takes the opposite side of the transaction. The firm and the dealer, in effect, swap the cash flow streams. Depending on what later happens to prices or interest rates, one party might gain at the expense of the other. In another type of arrangement, a firm might elect to tie the payments it makes on the swap contract to the price of a commodity, called a commodity swap, while in a different deal, a firm might buy an option to enter into a swap, called a swaption.
As we shall see later, swaps can be viewed as a combination of forward contracts, and swaptions are just special types of options.
Swaps make up slightly more than half of the $88 million national principal over-the-counter derivatives market. But swaps are only one of the many types of contracts that combine elements of forwards, futures, and options.
For example, a firm that borrows money at a floating rate in susceptible to rising interest rates. It can reduce that risk, however, by buying a cap, which is essentially an option that pays off whenever interest rate rises above a threshold. Another firm may choose to purchase an option whose performance depends not on how one asset performs but rather on better or worse performing of two or even more assets, called an alternative option.
Some of these types of contracts are referred to as hybrid because they combine an element of several other types of contracts. All of them are indications of the ingenuity of participants in today’s financial markets, who are constantly creating new and useful products to meet the diversified needs of the investors.
This process of creating new financial products is sometimes referred to as financial engineering. These hybrid instruments represent the effects of progress in our financial system. They are examples of change and innovation that have led to improved opportunities for risk management. Swaps, caps, and many other hybrid instruments are covered in the chapters to come.