A replacement swap is a type of investment strategy that involves arranging for an alternative swap before the original swap or exchange reaches full maturity. Typically, this type of replacement approach is applied when certain factors arise that make it necessary to end the current swap immediately. By implementing a replacement swap, the investor stands a better chance of offsetting any losses that may have occurred due to the early termination of the original swap by enjoying some sort of gains from the newly substituted swap.
There are a number of reasons why a replacement swap may be extended and implemented. In the event that trading laws and regulations change in some manner that affects the configuration of the original swap, the two parties may agree to terminate that swap early and structure a new swap that is in full compliance with the new regulations. In addition, this type of activity can come about due to the failure of one party to live up to the terms and conditions that govern the original swap, effectively defaulting on the original arrangement. Changes in tax laws or even the credit rating of one or both of the parties involved may also bring the original swap to an early end. With any of these scenarios, the implementation of a replacement swap can ease losses and allow the parties involved to at least receive some sort of benefit for their efforts.
In order for a replacement swap to occur, there is typically some effort to include similar assets in the substitution, and even seek to have the terms match as closely as possible. This means that if a currency swap was originally involved, there is a good chance that the replacement swap will seek to use at least one of the two original currencies as part of the new arrangement. When interest rates are involved with the assets used in the swap, some effort to obtain similar rates is often present. It is important to note that neither the securities involved or the rates of interest that apply must be exact matches in order to create a satisfactory replacement swap.
While the general idea of the replacement swap is to come up with a substitute for something that cannot continue for some reason, this does not mean that any of the investors involved must assume that the new deal will carry the same potential as the original one. Taking the time to approach the replacement with the same level of assessment, investigation, and projection is very important. Choosing to participate in the new swap should only occur if the investor believes that the deal has a reasonable level of potential in relation to the degree of risk assumed in order to participate in the investment strategy.