A Swap is a financial agreement by which two parties agree to trade cash flows with one another. The two separate cash flows are known as the legs of the swap agreement. Swaps are generally formed using cash flows based on interest rates or currencies. In the case of interest rate swaps the amount of money exchanged under a swap agreement is determined by what is known as the notional amount. The notional amount is determined when the agreement is arranged and is only used to determine the size of the legs of the agreement. That is, in an interest rate swap, neither party actually spends the notional amount but it is used to determine the amount of their interest payments.
Unlike interest rate swaps, currency swaps do require the exchange of the notional amount. In a currency swap two parties agree to pay the other party a principal amount over a pre-determined time period, however the payments are made in different currencies.
Often times currency swaps and interest rate swaps are combined to fit the specific needs of two parties. For instance, one company could agree to exchange fixed interest rate payments in dollars for floating interest rate payments in Japanese yen.
In the U.S., swaps are useful for many companies because they do not constitute a loan by Generally Accepted Accounting Principles (GAAP). This means that these transactions are not required to be listed on a company's balance sheet.
