Swap (Finance)

A swap is a derivative contract in which two parties agree to exchange streams of payments over a set period according to a formula. In the most common form, the interest rate swap, one party pays a fixed interest rate and the other pays a floating rate on the same notional amount. Other swaps exchange payments in different currencies, the return on an asset, or protection against a borrower's default.

Swaps are used by companies, banks, governments, insurers and hedge funds to manage interest rate risk, currency exposure and credit risk, and also to take speculative positions. Most are traded over the counter between dealers and clients under standard documents published by the International Swaps and Derivatives Association (ISDA), and since 2008 many standard swaps must be cleared through a central counterparty.

Imagine two neighbors with different heating plans. One pays a fixed monthly amount and worries he is overpaying; the other pays whatever gas costs that month and worries about a cold winter. They agree that each month the second will pay the first a fixed sum and the first will pay the second whatever the actual gas bill was. Neither changes supplier, but each now has the kind of bill he prefers.

A swap works the same way with money. A company with a floating-rate loan that wants predictable payments can agree with a bank to pay a fixed rate and receive the floating rate, which then covers its loan. The underlying loan stays in place; only the payment streams are exchanged.

The notional principal is not exchanged; it is only used to calculate payments. On each payment date the two legs are usually netted:

• $r_{\text{fixed}}$ is the agreed fixed rate.
• $r_{\text{float}}$ is the floating benchmark rate for the period, today usually an overnight rate such as SOFR compounded over the period.
• $N$ is the notional amount and $d$ the number of days in the period.

Suppose a company pays fixed at 4 percent and receives floating on a notional of $10 million, with annual payments and $d/360$ taken as 1 for simplicity. If the floating rate for the year averages 3.5 percent, the company pays a net $(0.04 - 0.035) \times 10{,}000{,}000 = 50{,}000$ dollars. If the floating rate instead averages 5 percent, it receives $100,000. At the start, the fixed rate is set so that the swap has a market value of about zero; afterwards its value moves with interest rates and is reported at mark-to-market value.

• Interest rate swaps. Fixed-for-floating or floating-for-floating exchanges in one currency; by far the largest category.
• Currency swaps. Exchanges of principal and interest in two currencies, used to fund in one currency and convert to another; see currency swaps and the shorter-dated FX swap.
• Credit default swaps. One party pays a regular premium and the other pays out if a named borrower defaults; see credit default swap.
• Total return and equity swaps. One party receives the full return on an asset, such as a share or index, in exchange for a funding rate; see total return.
• Commodity and inflation swaps. Fixed prices or inflation rates are exchanged for floating ones, used by airlines, utilities and pension funds.

A widely cited early deal was the 1981 currency swap between IBM and the World Bank, arranged by Salomon Brothers, which let the World Bank raise Swiss francs and German marks indirectly. ISDA was founded in 1985 and its master agreement made documentation standard, helping the market grow rapidly. For decades most floating legs referenced LIBOR; after manipulation scandals, regulators led a move to overnight risk-free rates, and the main US dollar LIBOR settings ended after 30 June 2023.

The Bank for International Settlements reported that the notional value of all OTC derivatives reached about $846 trillion at the end of June 2025, with interest rate contracts, mostly swaps, accounting for about 79 percent. Notional value greatly overstates the money at risk, because only net payments change hands; gross market values are a small fraction of notional amounts.

Swaps carry market risk, counterparty risk if the other side fails, liquidity risk, and legal risk; in 1991 the UK House of Lords ruled that the London Borough of Hammersmith and Fulham had no legal power to enter its swaps, voiding the contracts. Credit default swaps written by AIG were central to its rescue during the 2008 financial crisis. In response, the G20 agreed in 2009 that standardized OTC derivatives should be centrally cleared and reported to trade repositories, with margin rules for uncleared trades. These commitments were implemented through Title VII of the Dodd-Frank Act, overseen by the Commodity Futures Trading Commission and the SEC, and the EU's European Market Infrastructure Regulation (EMIR). Swaps are distinct from the swap lines central banks use to lend each other currencies, and from atomic swaps in crypto, which exchange tokens rather than cash flows.

• International Swaps and Derivatives Association (ISDA)
• Bank for International Settlements: OTC derivatives statistics at end-June 2025
• Commodity Futures Trading Commission (CFTC)