Replacement Swap

DEFINITION of 'Replacement Swap'

A substitute for a swap arrangement that is terminated before it matures. A swap may be ended early if there is a termination event or a default. If a swap is terminated early, both parties will cease to make the agreed-upon payments and the counterparty who caused the early termination may be required to pay damages to the other counterparty.

BREAKING DOWN 'Replacement Swap'

A replacement swap is likely to have different terms, or interest rates, than the original swap since market conditions usually will have changed. As such, the damages (called "termination payments") will factor in the difference in interest rates between the original swap and the replacement swap.

Possible termination events include legal or regulatory changes that prevent one or both parties from fulfilling the contract terms ("illegality"), the placement of a withholding tax on the transaction ("tax event" or "tax event upon merger"), or a reduction in one counterparty's creditworthiness ("credit event"). Failure to pay or a declaration of bankruptcy by either party are examples of default events. To give a real-life example, when Lehman Brothers declared bankruptcy in 2008, entities that were involved in swaps with Lehman had to seek replacement swaps.