Derivatives Markets – Robert L. McDonald : [PDF Download]

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“A swap is a contract calling for an exchange of payments over time. One party makes a payment to the other depending upon whether a reference price turns out to be greater or less than a fixed price that is specified in the swap contract. A swap thus provides a means to hedge a stream of risky payments.

By entering into an oil swap, for example, an oil buyer confronting a stream of uncertain oil payments can lock in a fixed price for oil over a period of time. The swap payments would be based on the difference between a fixed price for oil and a market price that varies over time.

From this description, you can see that there is a relationship between swaps and forward contracts. In fact, a forward contract is a single-payment swap.

It is possible to price a multi-date swap determine the fixed price for oil in the above example by using information from the set of forward prices with different maturities (i.e., the strip). We will see that swaps are nothing more than forward contracts coupled with borrowing and lending money.”

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