What is a swap?

A financial swap is a formalised agreement between at least two parties to exchange the cash flows or obligations of an asset or liability for another. Swaps started out as a fairly niche financial instrument in the early 1980s but have become one of the largest derivative markets in the world with billions of dollars worth of new contracts being traded monthly.

Swaps are traded exclusively over-the-counter (OTC) and the terms are frequently customised to best suit the requirements of both parties. Due to a higher risk of one party defaulting, traditional swaps are primarily utilised by large corporations and financial institutions and rarely by individual investors. More recently, a range of exchange traded funds (EFT) have emerged, which allow individual investors to gain exposure to swaps. 

Swaps explained 

Swaps are primarily used as a means of hedging potential future risk. Swaps work as derivative contracts, in which one party swaps (or exchanges) the values or cash flows of one asset for another. It’s common for the cash flow of one asset to be fixed with the other floating, based on an interest rate, index price or currency exchange rate.

The counterparties may have different opinions on the cash flow direction of the floating asset or they may seek to benefit from having more favourable financing terms in one asset while requiring another. While there are different types of swaps, looking at some of the most common ones is a good way to better understand the swap meaning.

Below is a list of some of the largest swaps in terms of market size as well as an explanation of each swap meaning with an example.   

Interest rate swap 

Interest rate swaps are forward contracts, in which one stream of interest payments is exchanged for another according to a predefined principal amount. They presuppose the exchange of a fixed rate for a floating rate. One party may have access to more favourable lending with a floating rate but prefers to have a fixed rate. They can “swap” their floating rate with another party in exchange for a lower fixed rate than they previously qualified for. 

Currency swap 

Currency swaps represent one of the largest swap markets and, like interest rate swaps, usually involve parties who have a comparative advantage in one currency compared to another. An American company might be able to borrow US dollars at a better rate than they can borrow Japanese Yen, for example. They can borrow dollars at the lower rate and swap their USD loan for a similar loan obtained by another party in Yen. 

Risks of swaps

As swaps are traded OTC there can be significant risks in excess of normal market risk. The 2010 Dodd-Frank Wall Street reform and consumer protection act added significant visibility to the market and served to reduce this excess risk substantially. Individual investors using ETFs also reduce the chance of a default. As swaps are customisable and allow for both parties to mutually benefit through risk hedging, the market is gradually expanding year over year.