A swap is an agreement between two counterparties
to exchange something (one "leg" of the swap) for something else
(the other "leg"). These things can be anything that has a financial
value. Typically they are quantities determined by some form of
interest rate, in an interest rate swap or derivative.
Interest rate swaps take many forms. Typically they consist of
a number of component swaps on a frequent basis according to a predetermined
Usually, one leg involves quantities that are known in advance,
known as the "fixed leg", the other involves quantities that are
not known in advance, known as the "floating leg". The floating
leg must therefore be reset against an agreed reference rate, which
will become known at some point before the payment or settlement
takes place. Ideally, the determination of the reference rate must
be outside the control of the counterparties, otherwise a conflict
of interest will arise. However, many financial products in the
retail market (such as capped mortgages) involve reference to a
managed interest rate which is actually controlled by the mortgage
provider. Typically, the reference rate is some figure made publicly
available by a third party information vendor, or by government
agencies. For example, BBA LIBOR.
Once a component of the floating leg is fixed (or "reset"), the
fixed and floating components can be swapped or settlement (typically
one or two days after the fixing date).
The present value of a vanilla swap can easily be computed using
standard methods of determining the present value of the components.
- Pricing and Hedging Swaps, Miron P. & Swannell P., Euromoney