Introduction to Financial Derivatives - Swap Contracts

To quickly reiterate, there are the following four basic derivatives:

- Forward contracts
- Futures contracts
- Swap contracts
- Option contracts

In this post we will look at swap contracts.

Swap Contracts
A swap contract is an agreement to exchange future cash flows.

A simple example:
You have found a great place to buy and you want a mortgage. So you go to the bank and you get a loan for the next 35 years where for the next 5 years you will be making an interest-only payments based on a floating rate of interest according to the Libor rate index. To reduce their exposure to changing interest rates, you enter into a fixed-floating swap agreement with another party. Under the terms of the swap contract, every month you will make an interest-only payment on a fixed rate (let's say 3.75 percent). In return, you will receive from the other party an interest-payment based on Libor with which to make your payment to the bank.