What is a 'Swap'
A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable, that is, based on a a benchmark interest rate, floating currency exchange rate or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.
BREAKING DOWN 'Swap'
Interest Rate Swaps
In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, say ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). LIBOR is at 1.7%, low for its historical range, so ABC management is anxious about an interest rate rise.
They find another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR plus 1.3% on a notional principal of $1 million for 5 years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 6% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.
Below are two scenarios for this interest rate swap: 1) LIBOR rises 0.75% per year, and 2) LIBOR rises 2% per year.
If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bond holders over the five-year period are $225,000:
in other words, $75,000 more than the $150,000 ABC would have paid if LIBOR had remained flat:
ABC pays XYZ $300,000:
and receives $225,000 in return (the same as ABC's interest payments to bond holders). ABC's net loss on the swap comes to $75,000.
In the second scenario, LIBOR rises by 2% a year. This brings ABC's total interest payments to bond holders to $350,000
XYZ pays this amount to ABC, and ABC pays XYZ $300,000 in return. ABC's net gain on the swap is $50,000.
Note than 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 their comparative advantage in fixed or floating rate lending markets.
The instruments exchanged in a swap do not have to be interest payments. Countless varieties of exotic swap agreements exist, but relatively common arrangements include commodity swaps, currency swaps, debt swaps and total return swaps.
Commodity swaps involve the exchange of a floating commodity price, such as the Brent Crude spot price, for a set price over an agreed-upon period. As this example suggests, commodity swaps most commonly involve crude oil.
In a currency swap, the parties exchange interest and principal payments on debt denominated in different currencies. Unlike in an interest rate swap, the principal is not a notional amount, but is exchanged along with interest obligations. Currency swaps can take place between countries: China has entered into a swap with Argentina, helping the latter stabilize its foreign reserves, and a number of other countries.
A debt-equity swap involves 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.
Total return swaps
In a total 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—without having to expend the capital to hold it.
An exchange of debt related interest rates between two parties ...
The rate of the fixed portion of a swap as determined by its ...
Similar in structure to a plain vanilla swap, the key difference ...
An agreement between two parties to exchange interest payments ...
A swap agreement created through the synthesis of two swaps differing ...
A type of swap arrangement in which two parties agree to exchange ...
InvestingInvestopedia explores the most common types of swap contracts.
MarketsAn interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
TradingFind out what makes currency swaps unique and slightly more complicated than other types of swaps.
Managing WealthPuzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
InvestingPlain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
MarketsA currency swap involves two parties exchanging a notional principal and interest to gain exposure to a desired currency.
TradingThe wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
Managing WealthThis technique can add diversity to your portfolio and lower your taxes. Find out how.
MarketsLIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
ETFs & Mutual FundsExplore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
Learn more about interest rate swaps and currency swaps, how these swaps are used and the difference between interest rate ... Read Answer >>
Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>