A swap is an exchange of financial flows between two companies or financial institutions. Money is not directly exchanged, but financial instruments like interest rates are. Here’s an example: Both you and your friend buy a $100,000 home. You get a fixed rate of 2% and he gets a variable rate that ends up being 1.6% for the first year. You say, “Shoot! I should have taken a variable rate!” He says, “Shoot, what have I got myself into if next year my rate increases to 3%?” You both agree to exchange (swap) your rates because you both think that it’s better for you. As a result, your friend pays the 2%, and in exchange, you pay the value of the variable rate. If the variable rate stays below 2% for a long time you will come out on top, however if it quickly climbs above 2% you will lose. You have swapped the risk with your friend, since each of you thought your initial choices were riskier than the other’s.
If your cousin Jimmy who works at Air Canada tells you that the airline’s sales are going through the roof, and no one else outside the company knows about it yet, you might be tempted to buy the company’s stock to get rich quick. Read more