 Close to forwards and futures, swaps are the contract between two counterparties for exchange of cash flows over time. There are three types of swaps, interest rate swaps, credit default swaps and currency swaps. Sometimes in international market, all of these three types of swaps may be combined, where any receipt in one currency in a country is exchanged for payment in another form of currency in a second current country. Now let's see how interest rate swaps work. We have an example, we have a firm with outstanding debt of 100 million dollars bearing a 9% rate of interest with the maturity of 10 years. So annual interest payment for 9 years is 9 million dollars for each year. This means that this interest payment is a fixed obligation for the firm. Also there is a balloon payment of 100 million dollars of loan as a principal payment at the end of the maturity, which is 10 years. We assume that firm is in leasing business and firm is providing short-term loans on short-term interest rates and the nature of the firm, we assume that is highly cyclical in nature. This means that there is a possible variation in the business revenues of the firm. So it might be difficult for the firm to make these debt payments. If we see the relationship between firms revenues and its cost, we see that the revenues of the firm are moving in line with the interest rates happening in the market, whereas the cost of the firms are relatively fixed. So the firm's preference over the interest rates will naturally be to have a floating rate loan rather than a fixed interest rate loan under an interest rate swap contract. Now a firm has two options to manage its loan. The first option is to borrow from a capital market. In this way, the firm can borrow 100 million dollars at a variable rate of interest, say the at-liber. And in this way, the firm can retire its outstanding fixed interest bearing loan, but generally it is an expensive mode to get a new loan at a flexible rate of interest in order to retire a fixed rate loan. The second option with the firm is to enter into an easy swap agreement. In this way, the firm can exchange its fixed rate obligation with the variable, for example, library-based floating rate obligation. Now how this swap agreement will work for the firm? Assume that the firm agrees to swap its fixed 9 percent loan with the current library rate of say 5 percent. Now if the library rate starts at 8 percent, it rises for three years to 11 percent, then it goes on declining at 7 percent for the rest of the maturity of the loan. We have a diagram here. If we see this diagram, we can conclude that how interest rate payments are stepped in this agreement. We see that the firm is owing 8.5 million dollars as interest in one year, 9.5 million dollars as interest in year two, 10.5 million dollars as interest in year three, 11.5 million dollars as interest in year four. But in later, the interest rate drops to 7 percent. In this way, the interest payment to the firm has also declined to the amount of 7.5 million. Now the firm is paying its loan from 8.5 percent, it is rising and then after three years, it is declining and it is 7.5 million dollars each of the year till the 10th year. But in return, the firm is getting a fixed amount of 9 million dollars in each year. Although there is a net difference of 0.5 million, the firm will be adjusting its cash load to the tune of 0.5 million, which is the net amount. And in this way, the firm is shaping its fixed obligation contract with the variable rate obligation. The second type of swap is the currency or the foreign exchange swaps. These are the swaps of obligation to pay cash flows in one currency for debt to pay in another currency. Currency swap is a tool for hedging risk in the international trade. Let's have an example like US firm exports goods to Germany with the expected export proceed of 100 million euro to occur. Now US firm is paying its all cost in US dollar but it is receiving its revenues in euro. So there is a chance that firm is exposing to exchange rate risk. Let's say for an exchange rate of 2 euro against 1 dollar, the firm's receipts of 100 million euro will be equal to 50 million dollars. But if the exchange rate goes to 3 euro is equal to 1 dollar, then the dollars proceed will be equal to 33.33 million dollars. Now the solution to this exchange risk is that firm can have a currency swap. Like for example, the firm can enter into a 5 year currency swap at a fixed term of 100 million euro for 50 million dollars each year. Now it is immaterial that up till the end of the contract what would be the exchange rate. The firm has nothing to do this varying exchange rate as it has pegged its exchange rate risk right now under a swap contract. The third type of swap is the credit default swap or CDS. In fact CDS is just like an insurance against a value loss due to the chance that a firm can go on a default for a debt. In CDS there are two types of counter parties named as C1 and C2. C1 is basically the protection buyer. It is in fact periodically pays CDS to the second party or C2 which is the protection seller. Now in exchange or in return C2 or the protection seller agrees to pay at some amount in case of default on the loan. Let's see an example how this CDS works. Let's see Mr. A contracts Mr. B for a loan of 200 million dollars. A agrees to pay a spread of LIBOR plus 5% B the lender although hesitant due to the associated credit risk yet he agrees to the loan but buys some protection for a 4% CDS spread from an insurer. Like in case of A's default the insurer will pay B the power amount and in exchange the insurer will receive 0.8 million dollars which is basically the 4% of the loan amount and that loan amount is we know that 200 million dollars and this 0.8 million dollars each year will be given to the insurer by the lender who is B till the life of the debt.