Swaps

Section: Swaps Estimated study time: 45 minutes Content: A swap is an OTC derivative contract in which two parties agree to exchange a series of cash flows over a specified period based on a notional principal amount. The notional principal is the reference amount used to calculate the cash flows — it is not exchanged between parties (with the exception of currency swaps at maturity). Swaps are the largest segment of the derivatives market by notional amount, with interest rate swaps dominating. Swaps can be thought of as portfolios of forward contracts: each exchange of cash flows on a settlement date is equivalent to a forward contract for that date. This insight is useful for pricing and understanding risk. Like other OTC derivatives, swaps carry counterparty risk, though central clearing through clearinghouses has become mandatory for many standardized swap types following post-2008 financial reforms. The most common swap type is the plain vanilla interest rate swap, where one party pays a fixed rate and receives a floating rate (or vice versa) based on the same notional principal in the same currency. The fixed-rate payer is "long the swap" (benefits when rates rise) and the floating-rate payer is "short the swap" (benefits when rates fall). Common motivations include: a company with floating-rate debt wanting to convert to fixed (to reduce cash flow uncertainty), or an insurance company with fixed-rate liabilities wanting to convert fixed assets to floating (to reduce duration). The fixed swap rate is set so that the swap has zero value at initiation — it is the rate that equates the present value of fixed payments to the present value of expected floating payments. Currency swaps involve the…