Contracts to hedge risk by exchange cash flows include Interest-Rate Currency Swaps Swaps

Swaps are contracts to hedge risk by exchanging cash flows. In an interest-rate swap, one firm

exchanges its fixed interest and principal payments for a series of payments based on a floating rate.

If a firm has debt with fixed charges, but its revenues fluctuate with interest rates, it may prefer to

swap for cash outflows based on a floating rate. The advantage is that revenues and the amounts of

debt service will then move in the same direction, and interest-rate risk will be reduced. A currency

swap is an exchange of an obligation to pay out cash flows denominated in one currency for an

obligation to pay in another. For example, a U.S. firm with revenues in francs has to pay suppliers and

workers in dollars, not francs. To minimize exchange-rate risk, it might agree to exchange francs for

dollars held by a firm needs francs. The exchange rate will be an average of the rates expected over

the life of the agreement.