A Swap is an agreement between two parties to swap two future payments or series of future payments on agreed dates. For example, if you borrow some money at a floating interest rate you can enter into an interest rate swap to receive this floating rate and pay away a fixed rate. This effectively changes your floating rate loan into a fixed rate loan.
At inception, when the contract is entered in to, both sides of the swap are expected to have equal value and hence there is no premium to be paid. As time progresses, the floating interest rate will change and may be bigger or smaller than the fixed interest rate. If the floating interest rate is bigger, then you expect to receive more than you pay out and hence the contract has a positive value. We call this value the “Mark to Market” (MTM).
Equally, the floating interest rate may be lower. The benefit of entering into this kind of swap is that it removes the uncertainty of having to pay the unknown floating interest rate. The risk has been hedged.
