Swap
What is Swap?
A swap is a derivative contract under which counterparties exchange specified cash flows or economic returns according to a formula, schedule, reference, and legal agreement.
Swap books require lifecycle controls beyond trade-date analysis. Resets, fixings, collateral, compression, novation, clearing, benchmark fallbacks, and termination events can change cash and exposure. Independent price verification should explain dealer differences rather than average them blindly. Risk reports should map sensitivities by curve, currency, counterparty, maturity, and collateral agreement and include liquidity needed under adverse margin scenarios.
Common swap types
Interest-rate swaps exchange fixed and floating payments, currency swaps can exchange interest and principal in different currencies, total-return swaps transfer asset performance, and credit-default swaps transfer specified credit risk. Commodity, equity, inflation, and volatility swaps also exist. Terms vary, and the statutory or regulatory meaning can be broader than market shorthand.
Example
A company pays fixed and receives floating on $100 million notional to offset floating-rate debt. Net swap receipts can reduce debt interest when rates rise, while payments increase when rates fall. The debt and swap should be assessed together. The notional normally scales payments and is not automatically exchanged or equal to maximum loss.
Valuation and cash flows
Swap value is the present value of expected net contractual cash flows under curves, spreads, volatility, correlation, credit, funding, and collateral assumptions. Value can start near zero and become material. Reset, compounding, day count, calendars, fallbacks, and payment lags matter. Dealers can quote par rates while balance-sheet value changes continuously afterward.
Clearing and counterparty risk
Standard swaps may be centrally cleared and margined, while others remain bilateral under master agreements. Clearing mutualizes and manages default risk but adds margin and liquidity demands. Bilateral netting, collateral, thresholds, guarantees, and close-out provisions determine exposure. Counterparty risk can be wrong-way when swap value rises as the counterparty weakens.
Risks and practical checklist
Swaps face market, model, basis, counterparty, funding, collateral, liquidity, legal, benchmark, and operational risk. Read master agreement, schedule, confirmation, and collateral terms. Validate notional, payer direction, index, spread, resets, dates, day count, settlement, clearing, and termination. Reconcile valuations and collateral daily, stress curve and default scenarios, and avoid inferring risk from notional alone.
Sources and further reading
- CFTC Glossary, U.S. Commodity Futures Trading Commission