Loans and money issues

A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The dollar amount of the payments exchanged is based on some predetermined dollar principal, which is called the notional principal amount or notional amount. The dollar amount each counterparty pays to the other is the agreed-upon periodic rate times the notional principal amount. The only dollars that are exchanged between the parties are the agreed-upon payments, not the notional principal amount. In a swap, there is the risk that one of the parties will fail to meet its obligation to make payments (default). This is referred to as counterparty risk.
Swaps are classified based on the characteristics of the swap payments. There are four types of swaps: interest rate swaps, interest rate-equity swaps, equity swaps, and currency swaps. In an interest rate swap, the counterparties swap payments in the same currency based on an interest rate. For example, one of the counterparties can pay a fixed-interest rate and the other party a floating interest rate. The floating-interest rate is commonly referred to as the reference rate. In an interest rate-equity swap, one party is exchanging a payment based on an interest rate and the other party based on the return of some equity index. The payments are made in the same currency. In an equity swap, both parties exchange payments in the same currency based on some equity index. Finally, in a currency swap, two parties agree to swap payments based on different currencies.
A swap is not a new derivative instrument. Rather, it can be decomposed into a package of forward contracts. While a swap may be nothing more than a package of forward contracts, it is not a redundant contract for several reasons. First, in many markets where there are forward and futures contracts, the longest maturity does not extend out as far as that of a typical swap. Second, a swap is a more transactionally efficient instrument. By this we mean that in one transaction an entity can effectively establish a payoff equivalent to a package of forward contracts. The forward contracts would each have to be negotiated separately. Third, the liquidity of some swap markets is now better than many forward contracts, particularly long-dated (i.e., long-term) forward contracts.