Swaps

Swaps are financial derivatives in which two parties exchange cash flows or other financial instruments over a defined period. The cash flows are typically based on a notional principal, which is not itself exchanged in many swaps, and payments are settled on specified dates according to the contract terms.

Common forms include interest rate swaps, currency swaps, and commodity swaps. In an interest rate swap, one party pays a fixed rate on the notional amount while the other pays a floating rate tied to a reference index such as SOFR or LIBOR. In a currency swap, parties exchange interest payments in different currencies and may also swap the principal at the start and end of the term. Commodity swaps involve payments tied to the price of a commodity, with one leg typically fixed and the other floating. There are also equity swaps and credit default swaps, among others.

Swaps are usually characterized by terms such as notional amount, payment frequency, maturity, and the rate formulas governing each leg. Net settlement is common, meaning only the difference between the two cash flows is paid. Most swaps are traded over the counter between financial institutions, but many are cleared through central counterparties and secured with collateral.

Valuation depends on the present value of expected future cash flows and is sensitive to changes in interest rates, exchange rates, or commodity prices. Swaps are used to hedge risk or to adjust exposure without buying or selling the underlying asset, and they can also be used for speculation. Risks include counterparty credit risk, market risk, and liquidity risk, with regulatory reforms promoting greater transparency and collateralization.