A swap is an agreement between two counterparties to exchange something (one "leg" of the swap) for something else (the other "leg"). These "things" can be anything that has a financial value, but in the financial world one leg is typically a stock or other investment property. Likewise the other leg is most often some sort of payment, often based on some sort of measurable interest rate. For instance a common swap might be "5000 shares of IBM for 50 points over the LIBOR" meaning one counterparty will receive the shares of IBM, and in exchange pay the other a fee as long as they keep them.
Usually, one leg involves quantities that are known in advance, known as the "fixed leg", the other involves quantities that are not known in advance, known as the "floating leg". The floating leg must therefore be "reset" against an agreed reference rate, which will become known at some point before the payment or settlement takes place. For instance the parties might agree to pay 50 points (.5%) over the LIBOR measured on the 1st trading day of every 3rd month. The payment schedule is often, but not always, timed to coincide with the resets.
Ideally, the determination of the reference rate must be outside the control of the counterparties, otherwise a conflict of interest will arise. However, many financial products in the retail market (such as capped mortgages) involve reference to a managed interest rate which is actually controlled by the mortgage provider. Typically, the reference rate is some figure made publicly available by a third party information vendor, or by government agencies. For example, BBA LIBOR.
Once a component of the floating leg is fixed (or "reset"), the fixed and floating components can be swapped or settled (typically one or two days after the fixing date).
The first swaps were commonly used as a way to hedge exposure to market risk for a low fee. For instance, if a trader decides to short sell a stock, there is considerable "market risk" if the stock price rises. In order to hedge that risk, the trader could enter a swap agreement for the same stock, paying a small fee to "hold" it while not actually having to pay for the stock itself. In this case if the stock price does rise, they simply end the swap and use the stock to pay off the short. In effect, they are buying insurance against their position. Known as total return swaps, in these contracts all cash flows, dividend payments for instance, are payed or received by the holder as if they owned the stock directly. Yet for accounting purposes they are off-balance sheet and do not appear as an asset (they do not legally own the stock in question).
Another common use of the swap was to avoid the British stamp tax on short sales. Unlike the SEC in the US, in England only the short sells are taxed, and in order to raise enough money to pay for the exchange, taxed at a fairly high rate. To avoid this tax it is possible to simply swap out a position, paying a small fee to the other counterparty instead of a larger fee to the British exchanges.
Another popular form of swap is the interest rate swap, which swaps fixed income investments (like corporate bonds) for a floating leg. Interest rate swaps allow parties to re-allocate their exposure to interest-rate fluctuations, typically by exchanging fixed-rate obligations for floating rate obligations.
Party A may hold a fixed-rate loan, party B a variable-rate loan. In a swap, A will make the payments on B's loan and vice versa. There is no change in the balance sheets of either party, because the principal, i.e. the underlying 'notional' amounts, stay where they were. In other words, what is called a $1 billion swap actually involves amounts much smaller than $1 billion.
An interest-rate swap is one of the more common forms of over-the-counter derivative security transactions.
The present value of a vanilla swap can easily be computed using standard methods of determining the present value of the components.
