What Is a Swap?
A swap is a derivative contract in which two parties agree to exchange, or swap, a series of cash flows over a set period. The payments are calculated on a notional amount, which itself usually never changes hands; only the difference between the two payment streams is settled.
The most common variety is the interest rate swap, where one party pays a fixed rate and receives a floating rate tied to a benchmark, while the other does the opposite. Other major types include currency swaps, credit default swaps, and equity or commodity swaps.
How It Works
Swaps trade over the counter, typically arranged through bank dealers, and many standardized interest rate swaps now clear through central clearinghouses. Each period, the two legs are netted: if the fixed rate is 4% and the floating benchmark sets at 5%, the floating payer owes the fixed payer 1% of the notional for that period.
Companies use swaps to change the character of their liabilities without refinancing. A borrower with floating-rate debt who fears rising rates can enter a swap to pay fixed and receive floating, effectively converting its debt to a fixed rate.
Example
Suppose a company has $100 million of floating-rate debt and enters a 5-year swap where it pays a fixed 4% and receives the floating benchmark. If the benchmark averages 5% in a given year, the company receives a net 1% of $100 million, or $1 million, which offsets its higher floating interest expense.
If the benchmark instead falls to 3%, the company pays a net $1 million on the swap, but its underlying debt costs less, so its all-in rate still ends up near the 4% it locked in.
Why It Matters
The interest rate swap market is one of the largest financial markets on earth, with hundreds of trillions of dollars in notional outstanding, and swap rates are key benchmarks for pricing corporate debt. Credit default swaps, meanwhile, let investors trade pure credit risk and played a central role in the 2008 financial crisis.
Rates and derivatives desks that trade swaps are cornerstone businesses within fixed income sales and trading, and swap mechanics come up frequently in markets interviews.
