Swap
An OTC derivative in which two parties exchange streams of cash flows over time, such as fixed-for-floating interest payments.
Formula
Net settlement = (Fixed Rate − Floating Rate) × Notional × Day-Count Fraction
A swap is an over-the-counter derivative contract in which two counterparties agree to exchange a series of cash flows on scheduled dates over the life of the contract. No principal usually changes hands — only the net difference between the two payment legs is settled.
The most common type is the interest rate swap, where one party pays a fixed rate and receives a floating rate (now benchmarked to SOFR after LIBOR's retirement), while the other does the reverse. Other major families include currency swaps (exchanging principal and interest in two currencies), credit default swaps (protection against default), and commodity and equity total-return swaps.
Swaps are used to convert exposure — for example turning a floating-rate loan into a synthetic fixed-rate one — and to speculate on rates. Since the post-2008 reforms, most standardized swaps clear through central counterparties, which collect margin and reduce the bilateral credit risk that defined the old OTC market.
Example
A firm with a $10M floating-rate loan at SOFR + 1.5% enters a swap to pay 4% fixed and receive SOFR. Its net cost becomes 4% + 1.5% = 5.5% fixed, regardless of where SOFR drifts — the floating leg of the loan and the floating leg received on the swap cancel out.
Related Terms
Derivative
A financial contract whose value is derived from the price of an underlying asset such as a stock, index, commodity, or currency.
IntermediateForward Contract
A private, over-the-counter agreement to buy or sell an asset at a predetermined price on a specified future date.
IntermediateHedging
Opening an offsetting position to reduce the net risk of an existing trade or portfolio against adverse price movements.
IntermediateNotional Value
The full economic exposure of a futures position: Futures Price × Contract Multiplier (or Contract Size).
IntermediateSOFR
Secured Overnight Financing Rate — the benchmark short-term interest rate based on actual overnight Treasury repo transactions, replacing LIBOR.
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