Swap
A swap is a derivative contract in which two parties exchange streams of cash flows — for example fixed for floating interest, or payments in two currencies. Swaps are mostly traded over the counter and are widely used to hedge or reshape risk.
Imagine a company with a floating-rate loan that wants fixed payments, and an investor who wants the opposite. Rather than refinancing, they can simply swap payment streams. That's the idea behind swaps, one of the largest derivatives markets in the world. This entry explains how swaps work, the main types and their risks.
- Category
- Derivatives
- Reading time
- 3 min
- Also called
- Swaps, Swap contract, Swap agreement
- Updated
Swaps in plain words
Swap contracts let two parties exchange revenue streams arising from underlying assets each holds.1
A company can, for example, use a currency swap to hedge exchange-rate risk.1
Currency swaps exchange interest payments — and sometimes principal — in different currencies.2
How a swap works, step by step
Two parties agree terms
Notional amount, rates, dates.
Define the legs
E.g. fixed vs floating.
Exchange payments
Usually only the net difference.
Value changes
As rates or prices move.
Collateral may be posted
To manage counterparty risk. See Counterparty Risk.
Terminate or mature
At the agreed end date.
Worked examples
Example 1 — Fixed for floating
Net $50kParty A pays 4% fixed; Party B pays floating at 3.5% on $10m notional for a year.
| A pays | $400,000 |
| B pays | $350,000 |
| Net payment | A pays B $50,000 |
Swaps exchange cash flow streams, often settling only the difference. See Interest Rate Swap.
Example 2 — Currency hedge
HedgedA US firm with UK revenue swaps £ payments into $ payments.
| Risk removed | GBP/USD swings |
Companies use currency swaps to hedge exchange-rate risk.1 See Currency and FX Swaps.
Example 3 — Credit protection
Protection boughtA bond investor pays 1% a year to receive payment if an issuer defaults.
| Instrument | Credit default swap |
Credit default swaps transfer credit risk between parties. See Credit Default Swap.
Main types of swaps
| Aspect | Exchanges | Common use |
|---|---|---|
| Interest rate swap | Fixed vs floating | Managing rate risk |
| Currency swap | Payments in two currencies | FX hedging |
| Credit default swap | Premium vs default payout | Credit protection |
| Total return swap | Asset return vs fee | Synthetic exposure |
Who uses swaps
Companies
Fixing loan costs. See Interest Rate Swap.
Banks
Managing balance-sheet risk.
Funds
Synthetic exposure and hedging. See Hedge Fund.
Central banks
Currency swap lines. See Central Bank.
Advantages and disadvantages
Advantages
- Flexible, customised hedging.
- Changes risk without moving assets.
- Deep, liquid market for major types.
Disadvantages
- Counterparty risk.
- Complex valuation.
- Leverage can hide risks.
Going deeper
Read as far as you need. Each level builds on the one before it.
Notional amounts
Beginner
The notional amount sets payment sizes but usually isn't exchanged — only the interest flows are.3
Clearing
Intermediate
Since 2008 reforms, many standard swaps are cleared through central counterparties to reduce default risk. See Central Counterparty.
Swaptions
Advanced
A swaption is an option to enter a swap later, adding flexibility for hedgers. See Swaption.
Common mistakes
Confusing notional with exposure
Risk is far smaller than notional.
Ignoring counterparty risk
Check collateral terms.
Over-hedging
Match swaps to real exposure.
Forgetting mark-to-market
Swap values swing with rates.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- A swap exchanges cash flow streams between two parties.
- Main types: interest rate, currency, credit default.
- Notional usually isn't exchanged.
- Swaps hedge or reshape risk.
- Counterparty risk is key.
Frequently asked questions
Why use a swap instead of refinancing?
Are swaps regulated?
Can individuals trade swaps?
Further learning
- Interest Rate Swap
The largest swap market.
- Currency and FX Swaps
Swapping currencies.
- Credit Default Swap
Swapping credit risk.
- Counterparty Risk
The key risk.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Swap Contracts (opens in a new tab) Checked .
- Corporate Finance Institute. Currency Swap Contract (opens in a new tab) Checked .
- Corporate Finance Institute. Interest Rate Swap (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.