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Swap

One of the most widely used derivatives, which represents an agreement between two firms/parties to exchange cash flows of two different investment positions at specified future times according to certain agreed-upon terms or rules. For example, an interest rate swap is an agreement to receive 6-month LIBOR rate and pay a fixed rate of 6% per year every six months for a period of 4 years on a notional principal of $200 million. The first swap contracts were traded in the early 1980s.

It is worth noting that a forward contract can be considered a simple example of a swap. A forward contract is, in effect, an exchange of cash flows on just one future date. A swap, in contrast, is typically cash flow exchanges on several future dates. Likewise, a swap can be viewed as an exchange of two bonds: a fixed-rate bond and a perfect floater. The swap's price will equal the premium (discount) on the fixed-rate bond, while the floater's cost is the par value.

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