What Is a Swap?
A swap is aderivativecontract through which two partiesexchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on anotional principal amountrelated to a loan or bond, although the security can be almost anything. Usually, the principal does not change hands.
Each cash flow comprises oneleg of the swap. One cash flow is generally fixed,while the other is variable and based on a benchmark interest rate,floating currency exchange rate, or index price.
The most common kind of swap is aninterest rate swap. Swaps do not trade on typical exchanges, and generally, retail investors do not engage in them. Rather, swaps are transacted over-the-counter (OTC) or on Security-Based Swap Execution Facilities (SEFs). They occur primarily between businesses or financial institutions.
- A swap is a derivative contract that involves the exchange of cash flows related to a financial security.
- Interest rate swaps are the most commonly used swaps and usually involve a fixed interest rate and a variable interest rate.
- Credit default swaps contributed to the causes of the 2008 financial crisis.
- Institutions evaluate their outlooks for, e.g., interest rate movements, when they consider entering into an interest rate swap.
- SOFR has replaced LIBOR as the benchmark short-term rate index used in some swaps.
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Understanding Swaps
In an interest rate swap, the parties to the contract exchange cash flows based on a notional principal amount of an underlying security. The amount of the principal is not actually exchanged. But the cash flows related to the interest rates are. Also, the swap can be an amortizing swap, where the underlying principle of a loan will decrease over time.
Parties undertake swaps in order tohedge(protect against)interest rate riskor tospeculate. For example, imagine that ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as theSecured Overnight Financing Rate (SOFR) plus 1.3% (or 130 basis points). Also, assume that SOFR is at 2.5%and ABC's management is anxious about an interest rate rise.
The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate ofSOFR plus 1.3%on a notional principal amount of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue.
In exchange, ABC agrees to pay XYZ a fixed annual rate of 5% on a notional value of $1 million for five years.ABC will benefit from the swap if rates rise significantly over the next five years. XYZ will benefit if rates fall, stay flat, or rise only gradually.
LIBOR is no longer used as a benchmark index rate for short-term loans between financial institutions. It will cease publication of rates on Sept. 30, 2024. The benchmark index now used is the Secured Overnight Financing Rate (SOFR) and its one-month, six-month, and nine-month extensions.
Calculations of Gains or Losses
Below are two scenarios for the interest rate swap described above. In the first scenario, SOFR rises 0.75% per year. In the second scenario, SOFR rises0.25% per year.Remember, XYZ, Inc. has agreed to make an annual payment to the ABC company in the amount of SOFR plus 1.3% on a principal amount of $1 million for five years. ABC has agreed to pay XYZ an annual amount equal to 5% of $1 million for that time period.
Scenario 1
AsSOFRrises by 0.75% per year, ABC's total interest payments to its bondholders over the five-year period (and paid by XYZ) amount to $265,000. But thanks to the swap, that figure is offset by a $15,000 gain. Let's break down the calculation:
| Libor + 1.30% | Variable Interest Paid by XYZ to ABC | 5% Interest Paid by ABC to XYZ | ABC's Gain/Loss | XYZ's Gain/Loss | |
| Year 1 | 3.80% | $38,000 | $50,000 | -$12,000 | $12,000 |
| Year 2 | 4.55% | $45,500 | $50,000 | -$4,500 | $4,500 |
| Year 3 | 5.30% | $53,000 | $50,000 | $3,000 | -$3,000 |
| Year 4 | 6.05% | $60,500 | $50,000 | $10,500 | -$10,500 |
| Year 5 | 6.80% | $68,000 | $50,000 | $18,000 | -$18,000 |
| Total | $265,000 | $250,000 | $15,000 | ($15,000) |
In this scenario, ABC did well because, thanks to the swap, it fixed its interest rate at 5%. ABC paid $15,000 less than it would have with the variable rate. XYZ's interest rate forecast was incorrect; the company lost $15,000 through the swap because rates rose faster than it had expected.
Scenario 2
In the second scenario, SOFR rises by 0.25% per year:
| Libor + 1.30% | Variable Interest Paid by XYZ to ABC | 5% Interest Paid by ABC to XYZ | ABC's Gain/Loss | XYZ's Gain/Loss | |
| Year 1 | 3.80% | $38,000 | $50,000 | ($12,000) | $12,000 |
| Year 2 | 4.05% | $40,500 | $50,000 | ($9,500) | $9,500 |
| Year 3 | 4.30% | $43,000 | $50,000 | ($7,000) | $7,000 |
| Year 4 | 4.55% | $45,500 | $50,000 | ($4,500) | $4,500 |
| Year 5 | 4.80% | $48,000 | $50,000 | ($2,000) | $2,000 |
| Total | $215,000 | $250,000 | ($35,000) | $35,000 |
In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. Because its interest rate forecast was correct, XYZ received $35,000 more than it paid out.
Additional Factors
This example does not account for the other benefits ABC might have received by engaging in the swap. For example, perhaps the company needed another loan, but lenders were unwilling to extend one unless the interest obligations on its other bonds were fixed.
In most cases, the two parties would act through a bank or other intermediary, which would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on theircomparative advantagein fixed orfloating-ratelending markets.
Other Swaps
Swaps involve more than interest rate payments. In fact, there are many types of swaps. However, relatively common arrangements include commodity swaps, currency swaps, debt swaps, and total return swaps.
Commodity Swaps
Commodity swapsinvolve the exchange of a floating commodity price, such as the Brent Crude oilspot price, for a set price over an agreed-upon period. Commodity swaps most commonly involve crude oil.
Currency Swaps
In acurrency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Cash flows are based on a fixed rate and a variable rate (which is based on the floating currency exchange rate). Unlike with an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations.
Currency swaps can take place between countries. For example, China has used swaps with Argentina, helping the latter stabilize itsforeign reserves. The U.S. Federal Reserve engaged in an aggressive swap strategy with European central banks during the 2010 European financial crisis to stabilize the euro, which was falling in value due to the Greek debt crisis.
Debt-Equity Swaps
Adebt-equity swapinvolves the exchange of debt for equity. In the case of a publicly-traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their capital structure.
Total Return Swaps
In atotal return swap, the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset—a stock or an index. For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus dividend payments of a pool of stocks.
Credit Default Swap (CDS)
A credit default swap (CDS) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower defaults on a loan. Excessive leverage and poor risk management in the CDS market were contributing causes of the 2008 financial crisis.
What Is the Purpose of a Swap?
A swap allows counterparties to exchange cash flows. For instance, an entity receiving or paying a fixed interest rate may prefer to swap that for a variable rate (or vice versa). Or, the holder of a cash-flow generating asset may wish to swap that for the cash flow of a different asset. The purpose of such a swap is to manage risk, to obtain funding at a more favorable rate than would be available through other means, or to speculate on future differences between the swapped cash flows.
How Is a Swap Structured?
A swap is a derivative product that typically involves two counterparties that agree to exchange cash flows over a certain time period, such as a year. The exact terms of the swap agreement are negotiated by the counterparties and are then formalized in a legal contract. These terms will include precisely what is to be swapped and between whom, the notional amount of the principal, the maturity of the contract, and any contingencies. The cash flows that are ultimately exchanged are computed based on the terms of the contract, which may involve an interest rate, index, or other underlying financial instrument.
Who Uses Swaps?
Swaps are mainly used by institutional investors such as banks and other financial institutions, governments, and some corporations. They are intended to be used to manage a variety of risks, such as interest rate risk, currency risk, and price risk.
Are Swaps Regulated?
Today, many swaps in the U.S. are regulated by the Commodities Futures Trading Commission (CFTC) and sometimes the SEC, even though they usually trade over-the-counter (OTC). Due to the Wall Street reforms in the 2010 Dodd-Frank Act, swaps in the U.S. must use a Swap Execution Facility (SEF), which is an electronic platform that allows participants to buy and sellswapspursuant to regulation. The regulation of swaps is aimed at ensuring that these financial instruments are traded in a fair and transparent manner, and to reduce the risk of systemic financial failure (since swaps were blamed, in part, for the 2008 financial crisis). The specific regulations that apply to swaps internationally vary by jurisdiction.
The Bottom Line
A swap is a derivative contract which sets forth how one party exchanges (or swaps) the cash flows or value of one asset for another. Swaps are over-the-counter contracts primarily between businesses or financial institutions, and are not generally intended for retail investors.
The most common type of swap is an interest rate swap, where the parties exchange fixed and variable interest rate flows based on a notional principal amount, Such swaps can be used to hedge interest rate risk or to speculate on future interest rate changes.
