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II. The Swaps Business
A. Swaps in General
1. Definition of a Swap
A swap is a bilateral agreement obligating the parties
(often referred to as counterparties) to exchange at specified
intervals (e.g., monthly, quarterly, semiannually) cashflows
ascertained from applying specified financial prices (e.g.,
interest rates, currency rates) to a specified underlying amount.
The specified underlying amount is either a notional principal
amount which is not exchanged (as usually occurs when the subject
matter of the swap is interest rates) or an amount which may
actually be exchanged (as usually occurs when the subject matter
of the swap is currency rates). The exchange of cashflows at the
periodic intervals is sometimes referred to as “periodic
payments” and is usually done on a net settlement basis. Each
party to a swap bears the risk that its counterparty will default
on its obligation to make a periodic payment, and, thus, that it
(the party) will not receive a periodic payment owed to it by the
counterparty.
2. Swaps Are Derivative Financial Products
Swaps are derivative financial products (financial
derivatives). A financial derivative is a bilateral agreement
the value of which is derived (as implied by its name) from the
performance of an underlying asset, reference rate, or index.
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