What Is a Swap?
A swap is a derivative agreement in which two parties exchange sets of cash flows according to predefined rules. Swaps are commonly traded over the counter and can be customized by notional amount, maturity, payment frequency and reference rate.
The notional principal is often used only to calculate payments and may not itself be exchanged, depending on the swap type.
Interest Rate Swaps
An interest rate swap is a derivative contract in which two parties exchange interest payments calculated on an agreed notional amount. In a standard plain-vanilla interest rate swap, one party pays a fixed interest rate and receives a floating interest rate, while the other party takes the opposite position.
Importantly, the notional amount is generally not exchanged between the parties. Instead, it serves as the reference amount used to calculate the interest payments.
For example, consider a company that has floating-rate debt but would prefer the predictability of fixed interest payments. The company could enter into an interest rate swap in which it pays a fixed rate and receives a floating rate. The floating-rate payment received from the swap can help offset the floating-rate interest payments on its debt, effectively transforming part of its exposure from floating to fixed.
For a party that receives the floating rate and pays the fixed rate, a simplified net payment for one payment period can be expressed as:
\[
\text{Net Payment}
=
N \times (R_{\text{floating}}-R_{\text{fixed}}) \times \Delta t
\]
where \(N\) represents the notional amount of the swap, \(R_{\text{floating}}\) represents the applicable floating interest rate for the period, \(R_{\text{fixed}}\) represents the fixed interest rate specified in the swap contract, and \(\Delta t\) represents the accrual fraction corresponding to the length of the payment period.
If the floating rate is higher than the fixed rate, the party receiving floating and paying fixed receives a positive net payment. If the floating rate is lower than the fixed rate, the net payment is negative and that party pays the difference.
For example, assume a swap has a notional amount of $10 million, the fixed rate is \(4\%\), the floating rate for the current period is \(5\%\), and payments are made semi-annually. For simplicity, assume the accrual fraction is \(\Delta t=0.5\).
The floating-rate payment is:
\[
\$10{,}000{,}000 \times 0.05 \times 0.5
=
\$250{,}000
\]
The fixed-rate payment is:
\[
\$10{,}000{,}000 \times 0.04 \times 0.5
=
\$200{,}000
\]
Therefore, the net payment to the party receiving floating and paying fixed is:
\[
\$10{,}000{,}000
\times
(0.05-0.04)
\times
0.5
=
\$50{,}000
\]
Instead of exchanging $250,000 and $200,000 separately, the parties can settle only the $50,000 difference.
If the floating rate for a future period falls below the fixed rate, the direction of the net payment reverses. For example, if the floating rate falls to \(3\%\) while the fixed rate remains \(4\%\), the party paying fixed and receiving floating would make a net payment of $50,000 for an equivalent six-month period.
This illustrates the central purpose of an interest rate swap: it allows market participants to change the nature of their interest-rate exposure without changing the underlying borrowing or investment itself.
Currency Swaps
Currency swaps exchange cash flows denominated in different currencies. They may involve exchanges of principal at inception and maturity as well as periodic interest payments. They are used by companies and financial institutions to manage long-term currency funding and cross-border financing exposures.
Credit Default Swaps
A credit default swap transfers credit risk. The protection buyer pays a periodic premium to the protection seller. If a defined credit event occurs, the contract provides compensation according to its settlement terms. A CDS therefore resembles credit protection, although its legal and market mechanics are those of a derivative contract.
Swap Valuation
At inception, a standard swap is generally priced so that the present value of the two legs is approximately equal. After market rates move, the fixed and floating legs can have different values, creating a positive market value for one counterparty and a negative value for the other.
Counterparty and Collateral Risk
Because swaps are often OTC contracts, counterparty credit risk is important. Modern derivatives markets use collateral agreements, margining and central clearing for many standardized swaps to reduce this exposure. Liquidity, basis and model risk can also be significant.
Key Takeaways
Swaps exchange cash-flow profiles rather than requiring outright purchases or sales of the underlying exposures. Interest-rate swaps reshape rate risk, currency swaps reshape funding and FX risk, and credit default swaps transfer credit risk.
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