What is Swap and Its Limitations

Swap can be defined as agreement between two parties to exchange a series of payment, the terms of which are predetermined is called swap. In simple terms when one party agree to exchange its financial instrument with other parties financial instrument is called swap. However there are certain limitations of using swap and here are some of them –

1. It is difficult to identify a counter-party to take the opposite side of the transaction. So suppose one company wants to swap $100000 it is not necessary that other company will also be willing to swap the same amount with same maturity and hence it is a shortcoming of swap market.

2. The swap deal cannot be terminated without the mutual agreement of the parties involved in the transactions, also it has significant amount of default risk in it and hence it is risky instrument to use.

3. Secondary market for swap is still not fully developed like that of equity or currency market and hence swaps are illiquid and cannot be easily traded like equities or currencies.

4. Since swap market is an over the counter market and not exchange controlled the parties have to look carefully into the creditworthiness of the counter-party because there is no exchange to guarantee about fulfilling of the obligations of the parties involved in swap.

Hence from the above one can see that swap has some limitations and that’s the reason why only big financial institutions and companies do swaps.

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