A swap is a financial contract between two counterparties in which a series of cash flows are exchanged with the goal of minimizing the risk of holding one instrument or a certain exposure.
They are often used for risk management purposes, though swaps can be used by institutional asset managers to bet on the direction of a particular market.
Who uses swaps?
Many countries’ governments use swaps to help manage risks associated with floating interest rates and foreign currency exposures.
Some companies use swaps to hedge their own interest rate and money-market exposures or their future revenue streams.
Even some individuals and smaller firms can find swaps to be useful tools for hedging or speculation.
There are various types of swaps, but swaps generally involve two parties exchanging cash flows over an agreed period of time.
These cash flows usually depend on some reference rate or variable, and sometimes they are fixed between both parties.
For example, an interest rate swap will see both parties exchange to pay interest on some principal amount in a fixed and floating rate in respect of the same period.
A downward movement in interest rates could see swaps used to lock in these fixed lower rates, while an upward trend may be hedged by using swaps to pay fixed rates and receive floating rates.
There are various types of swaps, including swaps where:
- the principal is repaid in the same currency as it was borrowed (e.g., an interest rate swap)
- the principal is paid in another currency (e.g., a cross-currency rate swap) or
- swaps that involve both currencies but also have other features such as variable or fixed rates (e.g., a total return indexation swap)
Let’s take a look at the most common types of swaps.
Interest rate swaps
One common type of swap is an interest rate swap (IRS), which refers to swaps dealing with interest payment obligations or receipts.
They involve two counterparties exchanging a stream of cash flows over an agreed time period based on either one or more benchmark interest rates. Classically, this meant a rate benchmark such as Libor (London Interbank Offered Rate), Euribor (Euro Interbank Offered Rate), or TBA – LIBOR (The Brokers Offered Rate).
Now that Libor is being phased out due to a series of rigging scandals, other interest rate benchmarks have been set up in their place, such as SOFR.
They will also usually involve the exchange of a final cash flow called the ‘termination payment’ or ‘termination value’ at some point determined by an agreed formula, analogous to a final principal payment for a bond.
For example, swaps based on Libor may stipulate that if one party swaps variable rates with another and it swaps back to fixed with them in the future, they must swap back to the same rate as the original swap or prevailing market rates.
These swaps can be used for hedging purposes, such as when companies use swaps to lock into interest rates for borrowing over various periods while protecting themselves from any significant rise or fall in interest rates.
Another important distinction is that an interest rate swap is an agreement between two counterparties to exchange cash flows that are based on a notional principal amount and an agreed interest rate or rates denominated in a single currency. Those denominated in two different currencies – i.e., a cross-currency interest rate swap – are typically called quanto swaps.
Cash flows as they pertain to interest rate swaps could involve periodic interest payments at agreed intervals, such as quarterly, semi-annually, or annually.
But the term ‘interest rate swap’ may also refer to swaps where there is only a single final value exchanged, often referred to as an ‘accreting swap’.
Swaps involving multiple cash flow exchanges can be divided into those with a principal repayment leg and those without.
The latter swaps could either have no final payment due upon maturity (a ‘bulleting swap’) or may involve a ‘balloon payment’ at the end – usually calculated so as to ensure that the present value of this is equal to the original notional principal amount.
One example of swaps involving both principal and interest would be swaps based on Libor where one party swaps variable rates with another and it swaps back to fixed with them in future, they must swap back to the same rate as the original swap or prevailing market rates.
The notional principal amount will often be used as the basis for determining the day count convention (and interest accruals if appropriate) but such agreements tend to vary between counterparties and swaps will therefore often contain a clause dealing with such terms.
Rather than paying coupon payments periodically, swaps can be set up to accrue interest on a notional principal amount. For swaps with no final maturity, the calculation of the final payment is based on an agreed formula that takes into consideration multiple factors, such as indices determined by reference rates, current market rates at the end date, etc.
In the above diagram:
A is currently paying the floating rate, but wants to reduce interest rate risk by paying a fixed rate.
B is currently paying the fixed rate but wants to pay a floating rate due to the nature of its asset and liability mix.
Both parties can enter into an interest rate swap agreement using a bank as an intermediary. The net result is that both A and B can ‘swap’ their existing set of obligations or exposures for their desired obligations or exposures.
Typically A and B do not transact directly with each other.
Each will set up a separate swap with a bank or other institution (e.g., hedge fund, nonbank institution).
For coordinating the deal, the bank will take a spread from the swap payments.
Futures swaps are an agreement between two counterparties to exchange cash flows of one asset for another at various pre-determined points in the future, usually according to a fixed schedule.
They will often use a fixed interest rate, and in some cases may involve a final lump sum payment or receipt upon maturity known as a ‘final settlement price’ agreed over the life of the swap contract.
For example, swaps based on Libor may stipulate that if one party swaps variable rates with another and it swaps back to fixed with them in the future, they must swap back to the same rate as the swap or prevailing market rates.
A basis swap refers to swaps where counterparties exchange either fixed-rate payments representing the difference between two floating-rate indices, or floating-rate payments based on a fixed spread relative to different floating-rate indices.
For example, swaps based on SOFR may stipulate that if one party swaps variable rates with another and it swaps back to fixed with them in the future, they must swap back to the same rate as the original swap or prevailing market rates.
A freight swap (also known as shipping swaps) is an agreement between two counterparties to exchange cash flows of both parties’ obligations relating to one leg of a freight contract for those related to the other leg of the same contract.
This results in each leg having its own price benchmark, which may be a specific trip/voyage or contract period.
A currency swap is an agreement between two counterparties to exchange cash flows of both parties’ obligations denominated in one currency for those denominated in another.
The term of the currency swaps may be either shorter than or longer than the terms of both debt instruments involved, so that each party will pay its own debt off quicker or slower than the other party’s debt.
To minimize risk or to take advantage of opportunities related to changes in currency values, companies might need cross-currency swaps.
This type of swap deals with cash flows denominated in different currencies and are most useful when one party expects to receive payments in one currency but have payments or liabilities denominated in another.
For example, an Australian company might borrow in US dollars to build a factory, but earn its income in Australian dollars.
If the value of the Australian dollar falls relative to the value of the USD, that presents a problem.
Because of that currency exposure, its assets shrink while its liabilities climb, causing a squeeze.
A cross=currency swap that measures the exposure and is tailored to the specific needs of the client can help avoid this potential issue.
This swap deal can also involve cash flows denominated in different currencies and are most useful when one party expects to receive payments in a currency whose real value is highly uncertain due to a history of inflation (or ongoing high inflation).
An option swap, or swaption, allows the purchaser the right, but not the obligation, to buy (or sell) predefined amounts of an underlying asset from (or to) the seller over a certain period of time at a pre-agreed price.
This type of swap usually specifies whether or not the option can be altered or terminated during its life cycle and how any such changes would affect the payment stream.
A commodity swap is an agreement between two counterparties to exchange cash flows of both parties’ obligations where at least one obligation is linked to a commodity.
This can include commodities like oil, copper, natural gas, or practically anything that could be considered a commodity.
Credit default swap
A credit default swap (CDS) is an agreement between two counterparties that one party (usually referred to as the protection buyer) will make a series of payments to the other (usually referred to as the protection seller) in return for payment should a credit event occur affecting the reference asset.
During its life cycle, a CDS, like other swaps, may be traded independently or can be terminated early by making an equivalent lump-sum payment or by exchanging cash flows. The terms are set out in agreements made at the outset.
Subordinated risk swaps
A subordinated risk swap (SRS), or equity risk swap, is a swaps agreement between two counterparties to exchange cash flows of both parties’ obligations where at least one obligation is linked to equity.
This type of swaps deals with cash flows denominated in different currencies and are most useful when one party expects to receive payments in a currency whose value depends on inflation.
An equity swap is a swaps agreement between two counterparties to exchange cash flows of both parties’ obligations where at least one obligation is linked to the change in value of a particular stock equity index.
In a typical equity swap, one party will agree to pay the other party a stream of payments that is based on the performance of an equity index or a basket of stocks. Less commonly, it is based on a single stock.
In exchange, the other party pays a fixed rate or another floating rate.
The two parties can agree to swap payments at regular intervals (e.g., every three months), or they can choose to settle up at the end of the contract period.
The equity that’s used as collateral in an equity swap can be shares of stock, an equity index (such as the S&P 500 or an MSCI index), or a basket of stocks.
Read more: Equity Swaps – What to Know
Other types of swaps
These types of swaps are not as common, but they’re a part of the swap landscape.
Total return swap
A total return swap is swaps agreement between two parties that consists of a series of exchanges over the life of the swaps.
The party paying the total return makes payments based on a notional amount, usually representing an investment in some security or index, which varies with the performance of that instrument. The other party makes payments initially set at the contracted rate and then adjusted to offset any change in interest rates during swaps’ life cycle .
Variance swaps are an over-the-counter financial derivative used to hedge risks and/or speculate on the price action of a certain asset, index, volatility measurement, interest rate, or exchange rate.
One leg of the variance swap pays an amount based on the realized variance of the price changes as it relates to the underlying asset, index, etc.). Because this is unknown ahead of time, it pays what’s commonly called a floating rate.
Price changes are typically noted as log returns. Normally these are taken on a daily timeframe based on some agreed-upon closing price (e.g., such as the 4 PM EST weekday close of a stock on the NASDAQ or NYSE).
The other leg of the swap pays a fixed amount. As suggested by the term fixed, this amount is known when entering the deal.
The net payoff to parties involved in the deal will be the difference between the fixed amount and the floating amount at the end of the deal.
This is much like a standard vanilla option when the premium is known once entered and the final payout is determined at expiry.
Like vanilla options, the variance swap is settled in cash at expiration.
However, occasionally, cash payments are made at some interval for purposes of maintenance margin.
This type of swap consists of exchanging cash flows denominated in different currencies but linked to one or several assets contained in a certain basket.
For example, China has historically managed its currency against what’s known as the CFETS basket, which is a mix of different currencies from around the world, roughly based on their importance in the global economy.
A forward swap is an agreement that swaps the difference between the contracted date and present value of cash flows occurring at a later date.
This type of swap offers more security than swaps since the later payoff is guaranteed.
It is also commonly called a deferred or delayed-start swap.
Constant maturity swap (CMS)
A constant maturity swap allows the purchaser to fix the duration of received flows on a swap.
In a constant maturity swaps contract, the buyer receives payments based on a floating interest rate and pays according to a predetermined fixed rate. In addition, these payments will continue over the life of the swaps agreement unless it reaches its termination date, at which point it would be exchanged for the notional value.
In particular cases such as CMS swaps, one party’s payment is linked to a reference portfolio’s average price during its life cycle, while the other party’s payment is linked to a reference rate.
The reference portfolio can consist of a predetermined basket of bonds or loans whose prices are directly accessible on the market.
An Asian swap is an agreement with early termination if predefined criteria are met, most commonly the average price of a security between start and end date of the agreement being different from by a certain amount. This type of swap requires additional conditions, such as a minimum number of days.
This is similar to the idea of an “Asian” option because it offers early termination when certain conditions are met based upon the average price of this asset over time.
Bond basis swap
This type of swap consists in exchanging floating-rate payments for fixed-rate payments linked to a swap’s underlying bond.
An offset swap is a swap agreement where the payout at maturity is calculated by adding together gains and losses generated during the swap’s life cycle.
If one leg has a loss equivalent to the swaps principal, then there is no payment (or vice versa).
Constant proportion portfolio insurance (CPPI) swap
A CPPI swap is a type of portfolio insurance where a trader or investor wants to set a floor on the dollar value of their portfolio, then will decide on asset allocation decisions based on that.
The concept of CPPI uses two different assets in a type of barbell approach. These consist of a risky asset (usually equities, ETFs, or mutual funds) and a conservative asset of either cash, cash equivalents, or safe government bonds.
The percentage allocated to each type of asset depends on how much “cushion” a portfolio has, which is defined as current portfolio value minus floor value, plus a multiplier coefficient. A higher multiplier denotes a more aggressive strategy.
A CPPI swap can be used to replicate buying protection from a given underlying asset at maturity in case that its price drops below an agreed upon level during the swap’s life cycle, paying the difference between the market’s price at time T and this predetermined level.
An amortizing swap is typically an interest rate swap where the notional principal for the interest payments declines over the life of the swap.
This rate can be tied to an interest rate benchmark (such as SOFR) or to the prepayment of a mortgage.
It is a useful type of tool for those who want to manage the interest rate risk involved in a certain funding or lending requirement, or investment program.
Zero coupon swap
A zero coupon swap is useful when one party has liabilities denominated in floating rates but would like to minimize their cash outlay.
A sell/buy-back swap consists swaps agreement between two parties for one party selling an asset to another party and simultaneously agreeing to repurchase it on a future date at a predefined price.
This is usually done because the asset has matured and the seller wishes to close their position, or because they wish to hedge other business activities such as exchanges transactions, among others.
Deferred rate swap
A deferred rate swap is useful for those who need funding right now but don’t find current interest rates attractive and believe rates may fall in the future.
A receive-fixed swap consists of an agreement between two parties where one party agrees to pay a fixed rate and another party agrees to pay a floating interest rate based on an underlying index (such as Libor, SOFR, Euribor, etc.).
Interest rate collar
An interest rate collar is a combination of puts and calls used to hedge against rises in interest rates over time while allowing returns from assets denominated in floating rates.
This type of swap is useful when one party wishes swaps limits losses from rising interest rates, while still accessing floating-rate cash flows.
An accreting swap is used by banks that have agreed to lend increasing amounts of money to their customers over time so that they may fund projects.
A forward swap is formed via the synthesis of two swaps differing in duration for the purpose of fulfilling the specific timeframe needs of an investor or company.
A forward swap is also known as a:
- forward start swap
- delayed start swap, or a
- deferred start swap
A quanto swap is a cross-currency interest rate swap in which one counterparty pays an interest rate in a separate currency to the other party but the notional amount in domestic currency.
The payor side of the swap may be paying a fixed or floating rate.
For example, a swap in which the notional amount is denominated in British pounds, but where the floating rate is set as USD SOFR, would be considered a type of quanto swap.
Quanto swaps are also commonly known as differential, rate-differential, or diff swaps.
Range accrual swap (range accrual note)
A range accrual swap (or range accrual note) is an agreement to pay a fixed or floating rate while receiving cash flows from a fixed or floating rate on days where a floating rate stays within a predefined range.
This enables swaps issuers to access the floating-rate market while at the same time hedging against rising rates.
Range accrual notes are also known as fixing note swaps.
Non-deliverable forwards (NDFs)
A non-deliverable forward is a swap agreement between two parties for an amount of foreign currency to be exchanged at a specified future date or during an agreed period.
Three-zone digital swap
A three-zone digital swap is a generalization of the range accrual swap.
The payer of a fixed rate receives a floating rate if:
a) that rate stays within a certain predefined range, or
b) a fixed rate if the floating rate goes above the range, or
c) a different fixed rate if the floating rate falls below the range
Swaps are legal agreements which fluidly trade cash flows over time. Swaps can be designed to function like a simple cap or floor, or like an exotic derivative with multiple embedded options that depend on various market factors.
As interest rates are the most fundamental backbone of finance, the simplest swaps only exchange two interest rate payments, commonly known as interest rate swaps. But there are dozens of kinds of swaps in practice.
While most swaps result from seeking exposure to returns on investment instruments, swaps are also created for hedging purposes.
Swaps are used by corporations, governments, and financial institutions to achieve various investment goals.
They are particularly useful for hedging interest rate risk, generating income from difficult-to-access markets, and for managing liabilities whose value depends on factors such as inflation rates, exchange rates, and other risk factors.
As swaps provide several benefits, including risk transfer, swaps are becoming increasingly popular over time.
However, swaps are also risky because they often involve counterparty risk. This means an institution may renege on its obligation if it can’t pay, among other reasons.