SWAPS !

Suppose that you have an adjustable-rate mortgage with principal of $200,000 and current payments of $10,000 per year.If interest rates double,your payments would increase dramatically.ypu could elimiate this risk by refinancing your mortgage and getting a fixed-rate mortgage,but the transactions cost could be high.A swap contract would be an alternative solution that wouls not entail renegotiating the mortgage contract.You would agree to make payment to a counterparty,say a bank,equal to a fixed interest rate applied to $200,000.In exchange, the bank would pay you a floating rate applied to $200,000. With this interest rate swap,you would use the floating-rate payments received from the bank to make your mortgage payments. The only payments you would make out of your own pocket would be the fixed interest payments to the bank,as if you had a fixed-rate mortgage. Therefore, a doubling of interest rates would no longer affect your mortgage payments.

A swap is a contract to exchange cash flows over the life of the contract.In the exzmple,you exchange cash flows of floating-rate debt for cash flows of fixed-rate debt.The principal used to compute the cash flows,called the notional amount, is not exchanged. The notional mount for swaps is generally much higher than $200,000.There are swaps involving exchange rates.different types of floating interest rate,equities,electricity and so on.

A swap is really just a portfolio of forward contracts. For example imaging a forward contract that pays the amount you would pay on your mortgage payments in ten years in exchange for the forward price.This forward contract would hedge one interest rate payment.If you entered such forward contracts for each future interest payment date you would have the equivalent of swap.Consequently, like forward contracts, the market's assessment of the present value of the cash flows of swap is zero at initiation of contract.