What is a Swap?

A swap is derivative. It acts as a contract by which two parties can exchange the interest rate on their loans. In swaps, one interest rate is generally fixed while the other is variable.

Let’s take a look at an example of an interest rate swap using two of the Firmo team members — Analisa and Johannes. Please note that this scenario is illustrative and fictional.

Analisa and Johannes independently decide to take out a loan for €1 million each. Analisa lives in Denmark. Her bank offers Analisa an interest rate that is fixed at 5%. Johannes lives in Germany. He is offered and gets a floating interest rate that fluctuates between 3–10%.

Johannes finds himself in a position where he needs a stable cash flow. Since they took loans of the same size, he asks Analisa if she wants to swap interest rates. Johannes suggests a deal where every month on an agreed date will report what the interest rate is and then swap the difference.

This means that if Johannes’ interest rate goes up to 7%, he has to pay Analisa a difference of 2%. If its goes down, then Analisa would have to pay him the difference.

Analisa suspects that Johannes’s interest rate will go down. So, she takes the deal and accepts the risk because she believes that she will make a profit on this deal. For this reason, she agrees to do the interest rate swap agreement with Johannes on the loans.

Interest rate swaps are one example of a derivative. Other examples include futures and options. Firmo Network makes it possible for derivatives, such as interest rate swaps, to be securely deployed as smart contracts on the blockchain. This is done through FirmoLang, a formally verified domain-specific language.

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