Swaps and hedges are not interchangeable terms, but the former is often used as the latter. A swap occurs when two parties agree to exchange cash flows based on a set principal. A hedge is when an investor tries to secure his income by agreeing to a set future price for a product.
Why Hedge?
Hedges are investments that are not necessarily designed to maximize profit, but rather to minimize risk. This is done in markets where prices tend to fluctuate and an investor wants to ensure a set amount of income in the future.
Swaps
Swap agreements are when one party agrees to pay a fixed price, while the other agrees to a floating price. So, with commodities, an investor who owns a lot of oil can agree to sell it in the future at a predetermined price, while another investor agrees to buy it from him at that price. If the price drops, the buyer still has to buy it at the higher price.
Swaps as Hedges
Swaps are only used as hedges by one half of the transaction. The person agreeing to sell is hedging by fixing the price. The person who agrees to buy, however, is not hedging. Rather, he is hoping that the market value will rise in the future, thus enabling him to buy the commodity at a lower price than he sells it for.
