Definition
Swaps are OTC agreements to exchange cash flow streams. The most common type—interest rate swaps—exchanges fixed-rate for floating-rate payments. Currency swaps exchange cash flows in different currencies. Swaps allow companies to manage exposure without changing underlying assets. The notional amount is not exchanged; only the net cash flow difference changes hands.
lightbulb Example
Company A has a variable-rate loan (SOFR+200bps) and wants fixed payments. Company B has a fixed 5% loan and wants floating exposure. They enter an interest rate swap: A pays B 4.5% fixed; B pays A SOFR. Both achieve their desired exposure.
verified_user Key Points
- Notional principal is never exchanged
- Most common: interest rate and currency swaps
- Used to manage rate, currency, and credit exposure
- ISDA Master Agreement governs most swaps