Swaps Explained

A swap is a contract in which two parties agree to exchange streams of cash flows over time. One stream is usually fixed or tied to one variable, the other to a different variable. Swaps let investors and companies change the kind of exposure they have without buying or selling the underlying assets: converting floating rate debt to fixed, borrowing in one currency while paying in another, buying credit protection or gaining stock market exposure without owning stocks. Swaps trade mostly over the counter, and the market's total notional amount runs into hundreds of trillions of dollars.

The main types of swaps#

Total return swaps#

In a total return swap, one party receives the full return of an asset, price changes plus income, and pays a financing rate plus a spread. The other party, usually a bank, holds the asset and hedges.

Total return swaps can hide leverage and concentration. Archegos Capital used total return swaps with several banks to build huge, concentrated stock positions without public disclosure. When the stocks fell in March 2021, Archegos could not meet margin calls, and banks lost more than $10 billion in total. See Archegos Capital.

Commodity swaps#

Producers and consumers use commodity swaps to fix prices. An airline might agree to pay a fixed price for jet fuel and receive the floating market price, often the monthly average, on a set volume. If prices rise, the swap pays the airline, offsetting higher fuel costs. See Asian Options and Energy Markets.

Inflation swaps#

In a zero coupon inflation swap, one party pays a fixed rate and the other pays realised inflation over the period. The fixed rate shows the market's inflation expectations and is closely watched alongside TIPS breakevens. Pension funds use inflation swaps to hedge inflation linked liabilities. See Inflation.

How swaps are valued#

At the start, most swaps are priced so their value is zero: the present value of what each side expects to pay is equal. Over time, as rates, prices or credit conditions change, the swap gains value for one side and loses for the other. Valuation uses discounting with relevant curves, now usually overnight rate curves such as SOFR. See Time Value of Money.

Why swaps are used#

• Hedging: change exposure to rates, currencies, commodities or credit.
• Cost efficiency: cheaper than trading the underlying assets.
• Customisation: tailor amounts, dates and terms.
• Speculation and relative value: take precise views.
• Balance sheet management: banks and companies reshape risks.

Risks#

• Counterparty risk: a party may fail to pay; mitigated by clearing and collateral. See Market, Credit and Counterparty Risk.
• Market risk: values move with underlying variables.
• Liquidity and margin risk: collateral calls can strain cash.
• Hidden leverage: exposures may not show up on balance sheets.
• Documentation and legal risk: swaps are governed by ISDA agreements with complex terms.

Regulation#

Post 2008 reforms, such as the Dodd Frank Act in the US and EMIR in the EU, required central clearing for many standard swaps, margin for uncleared swaps and trade reporting to swap data repositories, improving transparency.

Frequently asked questions#

What is a swap in finance?#

A contract in which two parties exchange streams of cash flows, such as fixed for floating interest or one currency for another, over a set period.

What is a total return swap?#

A swap where one party receives the full return of an asset and pays a financing rate, gaining exposure without owning the asset.

Are swaps risky?#

They carry market, counterparty and liquidity risks, and can hide leverage, as the Archegos collapse showed.

Next, learn how credit risk is priced in Credit Spreads.