Swap
Quick Definition
A derivative contract in which two parties exchange cash flows or financial instruments over a specified period.
What Is Swap?
A swap is an over-the-counter (OTC) derivative agreement where two counterparties agree to exchange sequences of cash flows for a set period. The most common type is an interest rate swap, where one party pays a fixed rate and receives a floating rate (or vice versa). Other varieties include currency swaps, commodity swaps, credit default swaps (CDS), and equity swaps. Swaps are used by corporations, financial institutions, and governments to manage risk, reduce borrowing costs, or gain exposure to different asset classes. Because swaps trade OTC rather than on exchanges, they carry counterparty risk. Post-2008 reforms introduced central clearing requirements for standardized swaps to reduce systemic risk. The notional value of the global swaps market exceeds hundreds of trillions of dollars, making it one of the largest segments of the derivatives universe.
Swap Example
- 1A company with a variable-rate loan enters an interest rate swap to pay a fixed 4% rate and receive floating SOFR, converting its variable debt to fixed
- 2A U.S. firm and a European firm enter a currency swap to exchange principal and interest payments in dollars and euros, accessing cheaper borrowing in each other's markets
Related Terms
Hedging
An investment strategy that uses offsetting positions to reduce the risk of adverse price movements in an existing asset or portfolio.
Credit Default Swap (CDS)
A derivative contract where one party pays periodic premiums to another in exchange for protection against a credit event like default on a bond or loan.
Interest Rate Risk
The risk that changes in interest rates will negatively impact the value of fixed-income investments.
Call Option
A contract giving the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specified time period.
Put Option
A contract giving the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specified time period.
Strike Price
The predetermined price at which the holder of an option can buy (call) or sell (put) the underlying asset upon exercise.
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