In financial markets
, the exchange
of interest payment
on two different investments
of some form. The point of this is that different borrowers
can get different conditions in different markets, and these are seldom uniform for different companies. This allows a comparative advantage
(and sometimes a direct advantage, as in the example below); by exchanging interest payments, two companies can get better rates than each would by itself.
I'll go directly onto an example. In August 1981, IBM and World Bank conducted the first known currency swap ever. At this point, the World Bank (which is Swizz) wanted to borrow money in Swiss Francs, and IBM (which is a US company) wanted to borrow the same amount in US dollars. They both wanted to do this by issuing bonds. Due to rarity value, IBM could issue bonds in the Swiss Francs at the same rate as the Swiss Treasury - the best possible rate for SFr (Swiss Francs), while it had a fairly "bad" rate at home - US Treasury plus 45 basis points (0.45%). The situation was similar for World Bank. It could issue dollar-denominated bonds at a rate of US Treasury plus 40 basis points (0.40%), while it had to pay Swiss Treasury plus 20 basis points (0.20%) for SFr. As you can see, IBM could borrow what World Bank needed (SFr) cheaper than World Bank could, and World Bank could borrow what IBM wanted - USD (US dollars) at a cheaper rate than IBM. The stage was ripe for a swap - IBM had the loan World Bank wanted, and the reverse was also true.
If the World Bank borrowed USD and lent them to IBM at US Treasury + 40 bp (basis points) it would lose no money, and IBM would get a better rate. If IBM borrowed SFr and lent them to the World Bank at Swiss Treasury + 10 bp, IBM would make ten bp, and so would the World Bank. If both of these loans were done, it would result in a profit to IBM of 15 bp, and a profit to the World Bank of 10 bp. Thus, World Bank and IBM implemented something like this.
Since IBM and World Bank both borrowed the same amount of money (the principal), there is no need to do all the money exchange the above implies. A number of the terms cancel against each other. If the money was actually moved around, IBM would intially get (principal) from World Bank, and World Bank would intially get (principal) from IBM. These cancel each other out, so no money is transferred initially. Each due date, IBM would be paying (interest on USD + 40 bp) to World Bank and recieving (interest on SFr + 10 bp) from World Bank. World Bank would be paying (interest on SFr + 10 bp) and recieving (interest on USD + 40 bp). These terms can be expressed as a difference: IBM would be receiving or paying (depending on the sign) ((interest on USD + 40 bp) - (interest on SFr + 10 bp)), which simplifies to (interest on USD - interest on SFR + 30 bp). World Bank would be on the opposite end of the transaction. This is all the exchange of money there is. In a "normal" transaction, IBM and World Bank would be paying the principals to each other at the end of the terms; however, as the principals were not exchanged in the first place, this is not necessary.
Note that as principals are never exchanged, the risk involved is much smaller than in a loan of similar size. (In the transaction above, the risk of default was close to zero, as both IBM and World Bank had an AAA credit rating.)
Financial institutions quicly took an interest in this technique. They tried to facilitate it by (for a fee) finding partners for companies that wanted to partake in a swap. This proved fairly difficult - there was a lot of companies interested in swaps, but the swaps were often too different to be reconciled. This was handled by introducing a new party: The swap dealer. A swap dealer will function as a market maker by being willing to take either side in a swap, and adjusting rates depending on how much inventory it has on each side. Any risk not offset by selling opposing swaps is offset in the currency market.
This provided the liquidity that allowed the swap market to really take off.
Today, there are two primary forms of swaps - currency swaps (similar to above), and interest rate swaps (between fixed and floating rates, both for borrowing and lending). Exotic swaps done over the counter (OTC) include such things as swapping a bond portfolio with a stock portfolio (done primarily to avoid capital gain taxes.) A futures contract can also be viewed as a form of swap.