What it means
The most common type is the interest rate swap. One side agrees to pay a fixed rate on an agreed amount called the notional and receives a floating rate in return, while the other side does the opposite; the notional itself is never exchanged.
Companies use swaps to change the character of debt they already have. A business with a floating-rate loan that wants certainty can swap into fixed payments, keeping the original loan exactly as it is and adding a separate contract that offsets the rate risk.
Other varieties follow the same logic. A currency swap exchanges payments in two different currencies, a commodity swap fixes the price of fuel or metal, and a credit default swap exchanges a regular premium for protection against a borrower defaulting.
Settlement is usually net and periodic. On each payment date the two legs are calculated, the smaller is subtracted from the larger, and only the difference moves, which keeps the cash flows small relative to the notional amount.
The nuances that trip people up are accounting and counterparty risk. A swap is a derivative that must be carried at fair value on the balance sheet, and hedge accounting is needed to stop that value swinging through profit; separately, a swap is only as good as the institution on the other side.
In practice
Real-world examples.
Example
A property developer funds a $25,000,000 building with a floating-rate facility but has fixed rental income for ten years. It swaps into a fixed rate so its financing cost matches the certainty of its revenue.
Example
An airline enters a commodity swap fixing the price of part of its jet fuel requirement for the next twelve months. Fuel prices later rise, the swap pays out, and the gain offsets the higher price paid at the pump.
Example
A British subsidiary of a US group borrows in dollars but earns pounds. A currency swap converts the dollar interest and principal profile into sterling, removing the exchange rate mismatch between its debt and its income.
Formula
Calculation
Fixed Leg = Notional x Fixed Rate x (Days / 360)
Floating Leg = Notional x Floating Rate x (Days / 360)
Net Settlement = Floating Leg - Fixed Leg, where a positive figure means the fixed payer receives cash
A manufacturer has a $10,000,000 floating-rate loan priced at a reference rate plus a 1.5% margin, and it wants certainty over its interest bill. It enters a one-year swap on a $10,000,000 notional under which it pays 4.5% fixed and receives the reference rate.
Over the year the reference rate averages 5.2%. The fixed leg is $10,000,000 x 0.045 = $450,000 and the floating leg is $10,000,000 x 0.052 = $520,000, so the manufacturer receives net $520,000 - $450,000 = $70,000.
On the loan itself it paid the reference rate plus margin, or 5.2% + 1.5% = 6.7%, which is $10,000,000 x 0.067 = $670,000. After the swap receipt its net interest cost is $670,000 - $70,000 = $600,000, an effective rate of 6.0%, which is exactly the 4.5% fixed rate plus the 1.5% margin it set out to lock in.Case study
Seen in the real world.
Latham Tool Works is a fictional engineering firm used here to illustrate how a swap changes a company's risk profile. It carried a $10,000,000 floating-rate term loan and had watched its interest bill move by more than $200,000 between two consecutive years, which made budgeting genuinely difficult.
Rather than refinance and pay early repayment charges, its finance director arranged a five-year interest rate swap with the same bank, paying 4.5% fixed and receiving the floating reference rate on a $10,000,000 notional. The loan stayed exactly as it was, and the swap simply neutralised the moving part of the cost.
Two years later rates had fallen, and the swap showed a mark-to-market loss of about $310,000 on the balance sheet. The board was uncomfortable until the auditors confirmed the position qualified for hedge accounting, so the movement sat in reserves rather than distorting reported profit, and the budgeting certainty the firm had bought was working exactly as intended.
Watch out
Common mistakes.
- Thinking the notional amount is at risk. Only the net difference between the two legs is exchanged, and the notional is simply a reference figure used to calculate the payments.
- Judging a swap by its mark-to-market value alone. A hedge showing a loss usually means the exposure it protects has moved favourably, which is the whole point of the arrangement.
- Assuming a swap can be cancelled cheaply. Unwinding early means paying or receiving the market value of the remaining term, which can be a large one-off amount.
Questions
People also ask.
Is a swap the same as a loan?
No, no principal is lent, and a swap only exchanges payment streams, although it is often arranged alongside a loan.
Why not just take a fixed-rate loan instead?
Sometimes that is better, but a swap keeps the existing facility and its covenants in place and can be sized and dated independently of the loan.
What happens if the other side fails?
The swap becomes an unsecured claim, which is why counterparties are usually banks and why collateral arrangements are common on larger trades.
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