Swap (finance)

A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.[1] The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds. Specifically, two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated.[2] Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.[2]

The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.[3]

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement.[4] Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding was more than $348 trillion in 2010, according to Bank for International Settlements (BIS)[5].

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange, the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product—which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as:

Notional swaps chart
The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid-2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008
Currency Notional outstanding (in USD trillion)
End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0
Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1], "OTC Derivatives Market Activity in the Second Half of 2006", BIS, [2]

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by Intercontinental Exchange.

Size of market

As the International Finance in Practice box suggests, the market for currency swaps developed first. Today, however, the interest rate swap market is larger. Size is measured by notional principal, a reference amount of principal for determining interest payments. The exhibit indicates that both markets have grown significantly since 2000, but that the growth in interest rate swap has been by far more dramatic. The total amount of interest rate swaps outstanding increased from $48,768 billion at year-end 2000 to $349.2 trillion by year-end 2009, an increase of 616%. Total outstanding currency swaps increased 417%, from $3,194 billion at year-end 2000 to over $16.5 trillion by year-end 2009.

Swap bank

A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. A swap bank serves as either a swap broker or swap dealer. As a broker, the swap bank matches counterparties but does not assume any risk of the swap. The swap broker receives a commission for this service. Today, most swap banks serve as dealers or market makers. As a market maker, a swap bank is willing to accept either side of a currency swap, and then later on-sell it, or match it with a counterparty. In this capacity, the swap bank assumes a position in the swap and therefore assumes some risks. The dealer capacity is obviously more risky, and the swap bank would receive a portion of the cash flows passed through it to compensate it for bearing this risk.

Swap market efficiency

The two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and/or the benefit of hedging long-run exchange rate exposure. These reasons seem straightforward and difficult to argue with, especially to the extent that name recognition is truly important in raising funds in the international bond market.

The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a cost savings via the quality spread differential (QSD). In an efficient market without barriers to capital flows, the cost-savings argument through a QSD is difficult to accept. It implies that an arbitrage opportunity exists because of some mispricing of the default risk premiums on different types of debt instruments. If the QSD is one of the primary reasons for the existence of interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. Thus, the arbitrage argument does not seem to have much merit. Consequently, one must rely on an argument of market completeness for the existence and growth of interest rate swaps. That is, all types of debt instruments are not regularly available for all borrowers. Thus, the interest rate swap market assists in tailoring financing to the type desired by a particular borrower. Both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types of swaps.

Interest rate swaps

Vanilla interest rate swap with bank
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.

Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.[2]

  • A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.
  • An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap.
  • A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.
  • An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.
  • A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes.
  • A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future.
  • An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.
  • A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.


The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative.[2] There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.[2]

Note that the discussion below is representative of pure rational pricing; however, insofar as it excludes credit risk, it is somewhat idealized. Current practice - i.e. since the 2007–2012 global financial crisis - is to price swaps under a "multi-curve" framework; see Interest rate swap #Valuation and pricing for formulae, and Financial economics #Derivative pricing for context.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:

, where is the domestic cash flows of the swap, is the foreign cash flows of the LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc.

LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the international market.

Arbitrage arguments

As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

  1. assume the position with the lower present value of payments, and borrow funds equal to this present value
  2. meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
  3. use the received payments to repay the debt on the borrowed funds
  4. pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short.

See also


  • Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006
  1. ^ "What is a swap?". Investopedia. Retrieved 14 October 2017.
  2. ^ a b c d e John C Hull, Options, Futures and Other Derivatives (6th edition), New Jersey: Prentice Hall, 2006, 149
  3. ^ "Understanding Derivatives: Markets and Infrastructure - Federal Reserve Bank of Chicago". chicagofed.org. Retrieved 23 September 2017.
  4. ^ Ross, Westerfield, & Jordan (2010). Fundamentals of Corporate Finance (9th, alternate ed.). McGraw Hill. p. 746.CS1 maint: Multiple names: authors list (link)
  5. ^ "OTC derivatives statistics at end-June 2017". www.bis.org. 2017-11-02. Retrieved 2018-07-16.

External links

2012 JPMorgan Chase trading loss

In April and May 2012, large trading losses occurred at JPMorgan's Chief Investment Office, based on transactions booked through its London branch. The unit was run by Chief Investment Officer Ina Drew, who has since stepped down. A series of derivative transactions involving credit default swaps (CDS) were entered, reportedly as part of the bank's "hedging" strategy. Trader Bruno Iksil, nicknamed the London Whale, accumulated outsized CDS positions in the market. An estimated trading loss of US$2 billion was announced, with the actual loss expected to be substantially larger. These events gave rise to a number of investigations to examine the firm's risk management systems and internal controls.

Asset swap

An asset swap refers to an exchange of tangible for intangible assets, in accountancy, or, in finance, to the exchange of the flow of payments from a given security (the asset) for a different set of cash flows.

Fixed bill

Fixed bill refers to an energy pricing program in which a consumer pays a predetermined amount for their total energy consumption for a given period. The price is independent of the amount of energy the customer uses or the unit price of the energy. Energy companies can offer this type of pricing by hedging the risks of fluctuating demand using weather derivatives.

Forward contract

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures – such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded over the counter (OTC), forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. In other words, the terms of the forward contract will determine the collateral calls based upon certain "trigger" events relevant to a particular counterparty such as among other things, credit ratings, value of assets under management or redemptions over a specific time frame, e.g., quarterly, annually, etc.

ICE Clear Credit

ICE Clear Credit LLC, a Delaware limited liability company, is a Derivatives Clearing Organisation (DCO) previously known as ICE Trust US LLC which was launched in March 2009.

ICE offers trade execution and processing for the credit derivatives markets through Creditex and clearing through ICE Trust™.

ICE Clear Credit LLC operates as a central counterparty (CCP) and clearinghouse for credit default swap (CDS) transactions conducted by its participants. ICE Clear Credit LLC is a subsidiary of IntercontinentalExchange (ICE). ICE Clear Credit LLC is a wholly owned subsidiary of ICE US Holding Company LP (ICE LP) which is "organized under the law of the Cayman Islands but has consented to the jurisdiction of United States courts and government agencies with respect to matters arising out of federal banking laws."

International Swaps and Derivatives Association

The International Swaps and Derivatives Association (ISDA ) is a trade organization of participants in the market for over-the-counter derivatives.

It is headquartered in New York City, and has created a standardized contract (the ISDA Master Agreement) to enter into derivatives transactions. In addition to legal and policy activities, ISDA manages FpML (Financial products Markup Language), an XML message standard for the OTC Derivatives industry. ISDA has more than 820 members in 57 countries; its membership consists of derivatives dealers, service providers and end users.

Janet Tavakoli

Janet Tavakoli is the President of Tavakoli Structured Finance, Inc., a Chicago-based consulting firm. She has had three books published on credit derivatives, structured finance, and the 2008 global financial crisis.

Outline of finance

The following outline is provided as an overview of and topical guide to finance:

Finance – addresses the ways in which individuals and organizations raise and allocate monetary resources over time, taking into account the risks entailed in their projects.

Rational pricing

Rational pricing is the assumption in financial economics that asset prices (and hence asset pricing models) will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.

Sharing economy

Sharing economy is an umbrella term with a range of meanings, often used to describe economic activity involving online transactions. Although government-to-peer (G2P) and business-to-peer (B2P) could be involved in sharing economy, peer-to-peer (P2P) or collaborative consumption-based initiative has attracted much attention and been widely used in sharing economy as opposed to G2P and B2P. Originally growing out of the open-source community to refer to peer-to-peer based sharing of access to goods and services, the term is now sometimes used in a broader sense to describe any sales transactions that are done via online market places, even ones that are business to business (B2B), rather than peer-to-peer. For this reason, the term sharing economy has been criticised as misleading, as some argue that even services that enable peer-to-peer exchange can be primarily profit-driven.However, many commentators assert that the term is still valid as a means of describing a generally more democratized marketplace, even when it's applied to a broader spectrum of services. Collaborative consumption, or the sharing economy, refers to resource circulation systems which allow a consumer two-sided role, in which consumers may act as both providers of resources or obtainers of resources.The exchange may be performed directly on a peer-to-peer basis, or indirectly through a mediator (ex. store, website, app); online or offline; for free or for other compensation (ex. money, points, services, etc.). This vision allows for a broader understanding of the sharing economy based on the overarching criteria of consumers' changing role capacity.The sharing economy is also known as collaborative consumption, collaborative economy, or peer economy. It refers to a hybrid market model of peer-to-peer exchange.

Such transactions are often facilitated via community-based online services. Uberization is also an alternative name for the phenomenon.The sharing economy may take a variety of forms, including using information technology to provide individuals with information that enables the optimization of resources through the mutualization of excess capacity in goods and services. A common premise is that when information about goods is shared (typically via an online marketplace), the value of those goods may increase for the business, for individuals, for the community and for society in general.Collaborative consumption as a phenomenon is a class of economic arrangements in which participants mutualize access to products or services, in addition to finding original ways to individual ownership. The phenomenon stems from consumers' increasing desire to be in control of their consumption instead of "passive 'victims' of hyperconsumption".

The consumer peer-to-peer rental market is valued at $26 billion (£15 billion), with new services and platforms emerging frequently.The collaborative consumption model is used in online marketplaces such as eBay as well as emerging sectors such as social lending, peer-to-peer accommodation, peer-to-peer travel experiences, peer-to-peer task assignments or travel advising, and carsharing or commute-bus sharing.The Harvard Business Review, the Financial Times and many others have argued that "sharing economy" is a misnomer. The Harvard Business Review suggested that the correct descriptor for the sharing economy in the broad sense of the term is "access economy". The authors write, "When 'sharing' is market-mediated—when a company is an intermediary between consumers who don't know each other—it is no longer sharing at all. Rather, consumers are paying to access someone else's goods or services."

Structured settlement factoring transaction

A structured settlement factoring transaction means a transfer of structured settlement payment rights (including portions of structured settlement payments) made for consideration by means of sale, assignment, pledge, or other form of encumbrance or alienation for consideration. In order for such transfer to be approved, the transfer must comply with Internal Revenue Code section 5891 and any applicable state structured settlement protection law.

Swap Execution Facility

A Swap Execution Facility (SEF) (sometimes Swaps Execution Facility) is a platform for financial swap trading that provides pre-trade information (i.e. bid and offer prices) and a mechanism for executing swap transactions among eligible participants.Swap Execution Facilities are regulated by the Securities and Exchange Commission and the Commodity Futures Trading Commission. The regulated trading of certain swaps is a result of requirements in the United States by the Dodd–Frank Wall Street Reform and Consumer Protection Act (in particular Title VII). Financial swaps have traditionally been traded in over-the-counter (OTC) markets. However, regulatory changes have driven reporting, clearing, and settlement functions to SEFs, which are much more tightly regulated. The SEF-execution mandate responds to one of the four derivatives-related European Union, have proposed similar changes in swap market structure but none have yet been adopted.As of October 2, 2013, any swap listed by a SEF may be traded by the parties on the SEF, but may also be traded off-SEF in any other lawful manner. The swaps that must be traded on SEFs are both subject to a CFTC-centralized clearing mandate and have been determined to be "made available to trade" (MAT) by at least one SEF. Four categories of interest rate swaps and two categories of credit default swaps are currently subject to clearing mandates.

Swaps Regulatory Improvement Act

The Swaps Regulatory Improvement Act (H.R. 992) is a bill that would amend the Dodd–Frank Wall Street Reform and Consumer Protection Act. The Swaps Regulatory Improvement Act would improve the ability of banks to use swaps as a tool for hedging risk. If Dodd-Frank is not amended, non-bank institutions will have to do many of the swap trades instead. H.R. 992 passed the House during the 113th United States Congress.

Exotic derivatives
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