What Are Swaps?

Reviewed by Akhilesh GantiFact checked by Yarilet PerezReviewed by Akhilesh GantiFact checked by Yarilet Perez

What Is a Swap?

A swap is a derivative contract. This financial agreement takes place between two parties to exchange assets that have cash flows for a set period of time. At the time the contract is initiated, the value of at least one of the assets being swapped is determined by a random or uncertain variable, such as an interest rate or a commodity price.

Key Takeaways

• In finance, a swap is a derivative contract in which one party exchanges or swaps the values or cash flows of one asset for another.
• Of the two cash flows, one value is fixed and one is variable and based on an index price, interest rate, or currency exchange rate.
• Swaps are customized contracts traded in the over-the-counter market privately, versus options and futures traded on a public exchange.
• The plain vanilla interest rate and currency swaps are the two most common and basic types of swaps.

What Is the Swap Market?

Swaps are unlike most standardized options and futures contracts, which means most individual investors aren’t really familiar with them or how they work. These financial instruments are customized contracts that trade on the over-the-counter (OTC) market between private parties. As such, they can’t be traded easily over an exchange. This means there is always some degree of counterparty risk involved.

But don’t be fooled. Just because they trade OTC doesn’t mean the swap market is illiquid or lacks enthusiasm. In fact, the opposite is true. It is one of the largest and most liquid markets in the world, and there are plenty of knowledgeable traders who want to take part as either buyers or sellers.

The market was introduced in the 1980s to help traders lock in prices for various assets, including commodities, foreign exchange rates, and interest rates. The notional value of outstanding contracts in the global OTC derivatives totaled $632.2 trillion by the end of June 2022, which was an increase of 3.6% from the same period in 2021. The gross market value for interest rate derivatives jumped 32.2% to $11.8 trillion by June 30, 2022.

The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swap market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements. That’s more than 15 times the size of the U.S. public equities market.

Important

Swaps can be divided into two general families:

1. Contingent claims, such as options
2. Forward claims, which include exchange-traded futures, forward contracts, and swaps

Players in the Swap Market

Swaps can be fairly complex, which means they’re unlike stocks and bonds. They require a deeper understanding of how the markets work. As such, this isn’t a market meant for your average investor. Instead, some of the key players in the swap market include banks and other financial institutions, governments, institutional investors, hedge funds, and corporations.

These entities often turn to the swap market for two main reasons: commercial needs and comparative advantage. The normal business operations of some firms lead to the exposure of certain types of interest rates or currencies that swaps can alleviate.

Consider a bank that pays a floating rate of interest on deposits and earns a fixed rate of interest on loans. This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.

In other cases, companies may get financing for which they have a comparative advantage, then use a swap to convert it to the desired type of financing. For instance, a U.S. firm may try to expand into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By using a currency swap, the firm ends up with the euros it needs to fund its expansion.

Note

Swaps come in many shapes and sizes, including commodity swaps, currency swaps, debt-equity swaps, and credit default swaps among others.

How to Exit a Swap Agreement

One party may find the need to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling exchange-traded futures or options contracts before expiration. There are four basic ways to do this:

1. Buy out the counterparty. Just like an option or futures contract, a swap has a calculable market value. As such, one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance or the party who wants out must secure the counterparty’s consent.
2. Enter an offsetting swap. Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
3. Sell the swap to someone else. Because swaps have calculable value, one party may sell the contract to a third party. As with the first strategy in our list, this requires the permission of the counterparty.
4. Use a swaption. A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2.

Examples of Swap Markets

Let’s look at two different examples of popular swap markets: the plain vanilla interest rate and plain vanilla foreign currency swap markets.

Plain Vanilla Interest Rate Swap Market

The most common and simplest swap market uses plain vanilla interest rate swaps. Here’s how it works: Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period.

Here, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the times between are called settlement periods. Interest may be paid annually, quarterly, monthly, or at any other interval since swaps are customized contracts,

For example, on Dec. 31, 2022, Company A and Company B enter into a five-year swap with the following terms:

Taking the information from the table above, at the end of 2007:

• Company A pays Company B $1.2 million ($20 million x 6%)
• Company B pays Company A $1.27 million ($20 million x (5.33% + 1%) since one-year LIBOR was 5.33% on Dec. 31, 2006

In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period.

Swap contracts normally allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a notional amount.

Note

London Interbank Offered Rate (LIBOR) is the interest rate offered by London banks on deposits made by other banks in the Eurodollar markets. The market for interest rate swaps frequently (but not always) used LIBOR as the base for the floating rate until 2020. The transition from LIBOR to other benchmarks, such as the secured overnight financing rate (SOFR), began in 2020.

Plain Vanilla Foreign Currency Swap Market

This market involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties involved exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are approximately equal to one another, given the exchange rate at the time the swap is initiated.

Let’s say Company C (a U.S. firm) and Company D (a European firm) enter into a five-year currency swap for $50 million with an exchange rate of $1.25 per euro. And let’s assume the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Remember, principal payments are made first and the parties net the interest payments against each other at the then-prevailing exchange rate.

If at the one-year mark, the exchange rate is $1.40 per euro, then Company C’s payment equals roughly $1.97 million and Company D pays $4.125 million. In practice, Company D would pay the net difference of $2,155,000 to Company C. The parties then exchange interest payments on their respective principal amounts at intervals specified in the swap agreement,

Assuming they make these payments annually beginning one year from the exchange of principal. Because Company C borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, pays interest in dollars, based on a dollar interest rate.

At the end of the swap, which is usually also the date of the final interest payment, the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time.

Who Regulates the Swap Market?

The swap market is regulated by the Commodity Futures Trading Commission (CFTC). This organization has rules in place to oversee the market thanks to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The goal of the CFTC is to “promote the integrity, resilience, and vibrancy of the U.S. derivatives markets through sound regulation.”

How Do Credit Default Swaps Work?

Credit default swaps are financial derivative contracts between two parties: buyers and sellers. They allow investors to transfer the credit exposure of fixed-income investments, such as bonds or securitized debt. The purchaser of a credit default swap pays a premium while the seller pays the value of the security and any interest payments if default takes place by the security’s issuer.

What Are Some of the Risks Associated With the Swap Market?

Swaps are complicated investments that require a great deal of experience and knowledge. This means that they are generally not meant for the average investor. Still, it’s a good idea to familiarize yourself with how they work. Swaps are derivative contracts between two parties who agree to exchange assets with cash flows for a specified period of time. Some of the major risks involved with this market include interest rate risk and currency risk. There is also counterparty risk involved, which means there is a chance that one party may not live up to their financial obligations.

The Bottom Line

Many small investors have some basic knowledge of stocks and bonds. But they may be unfamiliar when it comes to more complex securities like swaps. A swap is a financial contract between a buyer and seller who agree to exchange assets that come with cash flows for a specified period of time. But the cash flow comes with a catch: one is fixed while the other is variable. Traded over the counter, swaps are commonly used by banks, financial institutions, and institutional investors.

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