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With all the talk about swap regulation these days, we can’t help but ask, “what the heck are swaps?” Swaps are financial instruments used either to hedge against risk or to profit through speculation. Like other types of instruments of this sort, called derivatives, they are simply contracts between two parties, and their value is derived from the underlying security or market index on which the contract is based. Some are based on movements in interest rates, currency exchange rates or commodity prices.

A common swap is the interest rate swap. Consider a company that issued floating rate bonds - they have essentially borrowed money at a rate of interest tied to some interest rate benchmark such as LIBOR or prime. The company that issued the bonds is at risk of paying more to service its debt if interest rates were to rise. In order to protect itself, the company could structure a swap agreement allowing it to swap its floating rate payments for a higher fixed rate payment. It has removed the variability and risk of the floating rate bond. Essentially, the company has found a simple way to refinance its debt.

These days, there is a great deal of discussion on swaps because they have been virtually unregulated for many years. The concern is that without proper guidelines for valuation and disclosure, companies and the investing public are at great risk as corporations and investment houses use swaps on a regular basis. Stay tuned…