Swap

A swap is an over-the-counter (OTC) derivative agreement where two parties exchange cash flows over time based on different terms or references. The most common type is the interest-rate-swap, where one party pays fixed interest and receives floating interest, while the counterparty does the opposite. Swaps are used to manage interest-rate risk, currency risk, and credit risk. They are customizable, settled at maturity (no daily mark-to-market), and typically require no margin.

How a swap works

A bank borrows $100M at floating rate SOFR + 1%. The bank wants to lock in a fixed cost. It swaps with a counterparty:

• Bank pays: Fixed 5% per annum on $100M
• Bank receives: SOFR + 1% per annum on $100M
• Net result: Bank pays 5% (fixed); counterparty pays SOFR + 1% (floating)

The bank has transformed floating debt into fixed debt using the swap. No principal is exchanged; only the interest rate difference is settled periodically.

Interest-rate swaps

An interest-rate-swap exchanges fixed and floating interest on a notional principal. The swap makes sense when:

• A fixed-rate borrower believes rates will fall (wants floating).
• A floating-rate borrower believes rates will rise (wants fixed).

The swap lets them change exposure without refinancing the underlying bond.

Currency swaps

A currency-swap exchanges principal and interest in two different currencies. A US company with euros pays the euro obligation by swapping with a euro company that has dollar obligations. Both benefit by accessing each other’s funding markets.

Total-return swaps and credit swaps

A total-return-swap exchanges the return on one asset for another. A credit-default-swap transfers credit risk. Swaps are flexible enough to exchange almost any cash flow.

Customization and terms

Swaps are customized:

• Principal amount
• Tenor (duration)
• Fixed rate (negotiated)
• Floating rate index (SOFR, LIBOR, etc.)
• Payment frequency (quarterly, semi-annual)
• Day-count conventions

This flexibility makes swaps ubiquitous in fixed-income and treasury markets but creates a fragmented OTC market.

Settlement and counterparty risk

Swaps typically settle semiannually or quarterly on the payment dates. Unlike futures, which settle daily, swaps defer settlement, creating counterparty risk. If the counterparty defaults before maturity, the remaining stream of cash flows is lost.

Post-2008, many swaps are now cleared through central clearing houses to reduce counterparty risk.

Pricing swaps

A swap’s fair fixed rate is determined by the yield curve and forward rates. For a 5-year swap, the fixed rate is roughly the average of 5-year forward rates implied by the spot yield curve.

If market forward rates rise, swap rates rise, and the swap’s value to the fixed-rate receiver increases.

See also