Swap: Agreement between 2 parties to exchange cash flows in the future
Introduced for their use in risk management
Swap provides mean to hedge a stream of risky payments
The party who pays the fixed price and receives the floating price is the "fixed leg"
The counterparty is the "floating leg"
Swaps are forward contracts coupled with borrowing and lending
No initial premium
Swap specifies maturity date T, notional amount N, and fixed number of periods n
The fixed swap rate is as a weighted aberage of the forward prices, where zero-coupon bond prices are
used to determine the weights
A buyer with seasonally varying demand might enter into a swap, in which quantities vary over time
In a plain vanilla interest rate swap, there is maturity date T, notional principal P, and fixed number of
2 parties to the swap
Every period, the fixed leg pays the fixed rate and receives the floating rate payment
The principal is never exchanged