Swap (finance)

In finance, a swap is a derivative in which two parties agree to exchange one stream of cash flows for another, based on some agreed formula. An example is a floating-for-fixed interest rate swap, which calls for (a) payments by one party based on the product of a floating interest rate and a fixed amount, called the notional, in exchange for (b) payments by the counterparty based on the product of a fixed interest rate (e.g., three percent) and the same notional amount. This example illustrates the origins of the name "swap" because the instrument allows the parties to swap payment obligations based on two interest rates—a floating rate and a fixed rate.

Unlike future, forward, or option contracts, swaps do not usually involve the exchange of the principal during or at the end of the contract.

Swaps are primarily over-the-counter contracts involving sophisticated institutions. Retail investors do not generally engage in swaps. Swaps, like other derivatives, are often classified in one of five asset classes: (1) interest rate, (2) foreign exchange, (3) credit, (4) equity, and (5) commodity (e.g., energy, metals or other physical commodities. As of June 2025, the Bank of International Settlements reported the following estimates of swaps across the asset classes by notional outstanding and fair value (in billions USD):

{| class="wikitable"

|+ Swaps by Asset Class

! ___!! Notional !! Fair Value

| Interest Rate || 665,808 || 15,038

| Foreign Exchange || 155,173 || 5,351

| Credit || 11,302 || 301

| Equity || 10,398 || 822

| Commodity || 2,623 || 251

Bank for International Settlements IRS, FX & Equity. Bank for International Settlements Credit & Commodity.

History

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement. Today, swaps are among the most heavily traded financial contracts in the world.

Most swaps are traded over-the-counter and are drafted specifically for the counterparties. The United States's Dodd-Frank Act in 2010, however, established a multilateral platform for swap quoting, the swaps execution facility, mandating that swaps be reported to and cleared through exchanges or clearing houses. This subsequently led to the formation of swap data repositories (SDR), a central facility for swap data reporting and recordkeeping. Data vendors, such as Bloomberg, and large exchanges, such as the Chicago Mercantile Exchange, were among the first to register as SDRs. Other exchanges followed, such as the IntercontinentalExchange and Frankfurt-based Eurex AG.

According to the 2018 SEF Market Share Statistics, Bloomberg dominates the credit rate swap market with 80% share; TP dominates the FX dealer to dealer market (46% share); Reuters dominates the FX dealer to client market (50% share); Tradeweb is strongest in the vanilla interest rate swap market (38% share); TP is the biggest platform in the basis swap market (53% share); BGC dominates both the swaption and XCS markets; Tradition is the biggest platform for caps and floors (55% share).

Documentation

Swaps are generally drafted on ISDA documentation. The documentation consists of a master agreement between counterparties, a schedule to the master agreement that reflects changes from the defaults provided by ISDA's form, and confirmations for specific transactions. ISDA has been foundational to the development of swap documentation, and hence liquid, global markets for swaps. Swaps are different from futures and many options in that they are generally agreed to bilaterally between parties, rather than provided by an exchange.

Industry structure

Swap dealers (i.e., major institutions) supply swaps to the market. The dealing market is significantly concentrated. Some swaps are cleared through clearinghouses, i.e., derivatives clearing organizations. Other swaps are outstanding on a bilateral basis. Some swaps are executed through electronic platforms, while others are entered into through voice brokers or other means.

Swap market efficiency

Firms using currency swaps have statistically higher levels of long-term foreign-denominated debt than firms that use no currency derivatives. Conversely, the primary users of currency swaps are non-financial, global firms with long-term foreign-currency financing needs. From a foreign investor's perspective, valuation of foreign-currency debt would exclude the exposure effect that a domestic investor would see for such debt. Financing foreign-currency debt using domestic currency and a currency swap is therefore superior to financing directly with foreign-currency debt.

Types of swaps

The generic types of swaps, in order of their quantitative importance, are: interest rate swaps, basis swaps, currency swaps, inflation swaps, credit default swaps, commodity swaps and equity swaps. There are also many other types of swaps.

Interest rate swaps

400px|right|thumb|A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating, or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A, in return, makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Basis swaps

A basis swap involves exchanging floating interest rates based on different money markets. The principal is not exchanged. The swap effectively limits the interest-rate risk as a result of having differing lending and borrowing rates.

Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency.

Just like interest rate swaps, the currency swaps are also motivated by comparative advantage.

Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction

being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.

Inflation swaps

An inflation-linked swap involves exchanging a fixed rate on a principal for an inflation index expressed in monetary terms. The primary objective is to hedge against inflation and interest-rate risk.

Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Credit default swap

An agreement whereby the payer periodically pays premiums, sometimes also or only a one-off or initial premium, to the protection seller on a notional principal for a period of time so long as a specified credit event has not occurred. The credit event can refer to a single asset or a basket of assets, usually debt obligations. In the event of default, the payer receives compensation, for example the principal, possibly plus all fixed rate payments until the end of the swap agreement, or any other way that suits the protection buyer or both counterparties. The primary objective of a CDS is to transfer one party's credit exposure to another party.

Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.

Equity swap

An agreement to exchange future cash flows between two parties where one leg is an equity-based cash flow such as the performance of a stock asset, a basket of stocks or a stock index. The other leg is typically a fixed-income cash flow such as a benchmark interest rate.

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.

A constant maturity swap (CMS) is a swap that allows the purchaser to fix the duration of received flows on a swap.
An amortizing swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.