A swap is an agreement between counter parties to exchange one asset for another. For example
|Party-A in USA needs pounds in UK for business||Party-B in UK needs dollars in USA for business|
They can enter a swap contract to carry out their businesses.
One of the most popular types of swap is known as currency swap. In its simplest form, it involves the exchange of principle and interest payments. In these type of contracts the principle is used for a specified time period. Consider the above example again
|Party-A in USA needs 10 million pounds in UK for three years||Party-B in UK needs 15 million dollars in USA for three years|
|The interest rate on dollars in USA is 6%||The interest rate on pounds in UK is 5%|
The exchange rate at the time of swap is $1.5/1 pound. And, they enter a swap contract for thee years.
The Party-A pays 15 million dollars and receives 10 million pounds. And each year it pays interest 0.05(10 million) = 0.5 million pounds, and receives interest 0.06(15 million) = 0.9 million dollars.
The Party-B pays 10 million pounds and receives 15 million dollars. And each year it pays interest 0.06(15 million) = 0.9 million dollars, and receives interest 0.05(10 million) = 0.5 million pounds.
The following table shows these cash flows.
In the end, both parties have received their principles back and have paid others principles.