Swap

What Is a Swap?

A swap is an agreement between two parties to exchange future cash flows according to rules set when the contract is signed. Swaps are usually traded over the counter, meaning they are privately negotiated rather than listed on an exchange, although some are now cleared through central clearing houses. Each side of the agreement is called a counterparty.

Most swaps are built around a notional principal, a reference amount used only to calculate payments. The notional itself is normally not exchanged.

How Swaps Work

The most common type is the interest rate swap. In a typical plain-vanilla version, one party pays a fixed rate on the notional amount while the other pays a floating rate tied to a benchmark interest rate. Payments are usually netted, so only the difference changes hands on each payment date.

Other common types include currency swaps, which exchange principal and interest in different currencies, and credit default swaps, which transfer the risk that a borrower fails to repay.

Example

Suppose two companies agree to a notional amount for several years. One company pays a fixed rate on that amount and receives a floating rate, while the other does the reverse. If the floating rate rises, the company receiving it gains from the arrangement. If it falls, that company pays the difference. Neither company has to lend or repay the notional amount itself. Only the net payments move between them.

Why It Matters to Investors

Companies, banks, and funds use swaps to manage interest rate, currency, or credit exposure, and some use them for speculation. For individual investors, swaps matter because they can affect the companies and funds they hold. Counterparty risk, the chance that the other side fails to make its payments, is a real consideration. Swaps can also be ended early, but this usually requires a negotiated settlement. Because these contracts are complex and often private, their terms are rarely visible to retail investors directly.