# Understanding Swaps: Definition, Uses, and Calculating Gains

## What Is a Swap?

A swap is a derivative contract where two parties exchange cash flows or liabilities of financial instruments, often over-the-counter (OTC) or on SEFs. Interest rate swaps, among the most common forms, typically involve fixed and variable rates between institutions seeking to manage interest rate risk or speculate on market conditions.

### Key Takeaways

*   A swap is a derivative contract in which two parties exchange the cash flows or liabilities of different financial instruments.
*   Interest rate swaps are the most common type of swaps, often involving a fixed interest rate and a variable interest rate.
*   Swaps are primarily used by institutional investors to manage risks such as interest rate risk and are conducted over the counter or on Swap Execution Facilities.
*   The proper structuring of swaps can offer financial advantages like hedging against interest rate rises or optimizing fiscal costs.
*   Swaps are regulated by bodies like the Commodity Futures Trading Commission and the Securities and Exchange Commission to ensure transparency and reduce systemic risk.

![Swap](https://www.investopedia.com/thmb/nEMqm6g-3Sj7CwvkFYMMS9Oo-js=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Term-Definitions_swap-27b93a31e83c423a854db04030a67673.jpg)

*— Jessica Olah / Investopedia*

## Deep Dive Into Interest Rate Swaps

In an interest rate swap, the parties exchange cash flows based on a notional principal amount of an underlying security, though the principal itself isn't exchanged. Instead, the cash flows related to interest rates are exchanged. A swap can also be amortizing, meaning the loan's principal decreases over time.

Parties undertake swaps in order to [hedge](https://www.investopedia.com/terms/h/hedge.asp) (protect against) [interest rate risk](https://www.investopedia.com/terms/i/interestraterisk.asp) or to [speculate](https://www.investopedia.com/terms/s/speculation.asp). For example, imagine ABC Co. issues $1 million in five-year bonds with a variable interest rate set at the [Secured Overnight Financing Rate (SOFR)](https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954) plus 1.3%. If the SOFR is 2.5%, management may worry about rising rates.

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of the SOFR​ plus 1.3% on a notional principal amount of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. 

In exchange, ABC agrees to pay XYZ a 5% fixed rate on a notional value of $1 million for five years. ABC benefits if rates rise significantly, while XYZ benefits if rates fall, stay the same, or rise gradually.

> **Important**
>
> LIBOR is no longer used as a benchmark index rate for short-term loans between financial institutions. It will cease publication of rates on Sept. 30, 2024. The benchmark index now used is the Secured Overnight Financing Rate (SOFR) and its one-month, six-month, and nine-month extensions.

## How to Calculate Gains or Losses in Swaps

Below are two scenarios for the interest rate swap described above. In the first scenario, the SOFR rises 0.75% per year. In the second scenario, the SOFR rises 0.25% per year. Remember, XYZ Inc. has agreed to make an annual payment to the ABC company in the amount of the SOFR plus 1.3% on a principal amount of $1 million for five years. ABC has agreed to pay XYZ an annual amount equal to 5% of $1 million for that time period.

### Scenario 1

As the SOFR rises by 0.75% per year, ABC's total interest payments to its bondholders over the five-year period (and paid by XYZ) amount to $265,000. But thanks to the swap, that figure is offset by a $15,000 gain. Let's break down the calculation:

In this scenario, ABC did well because, thanks to the swap, it fixed its interest rate at 5%. ABC paid $15,000 less than it would have with the variable rate. XYZ's interest rate forecast was incorrect; the company lost $15,000 through the swap because rates rose faster than it had expected.

### Scenario 2

In the second scenario, the SOFR rises by 0.25% per year:

In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. Because its interest rate forecast was correct, XYZ received $35,000 more than it paid out.

### Factors Influencing Swap Outcomes

This example does not account for the other benefits ABC might have received by engaging in the swap. For example, perhaps the company needed another loan, but lenders were unwilling to extend one unless the interest obligations on its other bonds were fixed.

Usually, parties use a bank or intermediary, which takes a cut of the swap. Deciding whether to enter an interest rate swap depends on their [comparative advantage](https://www.investopedia.com/terms/c/comparativeadvantage.asp) in fixed- or [floating-rate](https://www.investopedia.com/terms/f/floatinginterestrate.asp) markets.

## Exploring Different Types of Swaps

Swaps involve more than interest rate payments. In fact, there are many [types of swaps](https://www.investopedia.com/articles/investing/052915/different-types-swaps.asp). However, relatively common arrangements include commodity swaps, currency swaps, debt swaps, and total return swaps.

### Commodity Swaps

[Commodity swaps](https://www.investopedia.com/terms/c/commodityswap.asp) involve the exchange of a floating commodity price, such as the Brent Crude oil [spot price](https://www.investopedia.com/terms/s/spotprice.asp), for a set price over an agreed-upon period. Commodity swaps most commonly involve crude oil.

### Currency Swaps

In a [currency swap](https://www.investopedia.com/terms/c/currencyswap.asp), the parties exchange interest and principal payments on debt denominated in different currencies. Cash flows are based on a fixed rate and a variable rate (which is based on the [floating currency exchange rate](https://www.investopedia.com/terms/f/floatingexchangerate.asp)). Unlike with an interest rate swap, the principal is not a notional amount, but it is exchanged along with interest obligations.

Currency swaps can occur between countries. For instance, China used swaps with Argentina to stabilize its [foreign reserves](https://www.investopedia.com/terms/i/international-reserves.asp), and the [U.S. Federal Reserve](https://www.investopedia.com/terms/f/federalreservebank.asp) employed swaps with European [central banks](https://www.investopedia.com/terms/c/centralbank.asp) during the 2010 financial crisis to stabilize the euro.

### Debt-Equity Swaps

A [debt-equity swap](https://www.investopedia.com/terms/d/debtequityswap.asp) involves the exchange of debt for equity_._ In the case of a publicly traded company, this would mean bonds for stocks. It is a way for companies to refinance their debt or reallocate their [capital structure](https://www.investopedia.com/terms/c/capitalstructure.asp).

### Total Return Swaps

In a [total return swap](https://www.investopedia.com/terms/t/totalreturnswap.asp), the total return from an asset is exchanged for a fixed interest rate. This gives the party paying the fixed-rate exposure to the underlying asset_—_a stock or an [index](https://www.investopedia.com/terms/m/marketindex.asp). For example, an investor could pay a fixed rate to one party in return for the capital appreciation plus [dividend](https://www.investopedia.com/terms/d/dividend.asp) payments of a pool of stocks.

### Credit Default Swap (CDS)

A [credit default swap (CDS)](https://www.investopedia.com/terms/c/creditdefaultswap.asp) consists of an agreement by one party to pay the lost principal and interest of a loan to the CDS buyer if a borrower [defaults](https://www.investopedia.com/terms/d/default2.asp) on a loan. Excessive [leverage](https://www.investopedia.com/terms/l/leverage.asp) and poor risk management in the CDS market were contributing causes of the 2008 financial crisis.

## What Is the Purpose of a Swap?

A swap allows counterparties to exchange cash flows. For instance, an entity receiving or paying a fixed interest rate may prefer to swap that for a variable rate (or vice versa). Or, the holder of a cash-flow-generating asset may wish to swap that for the cash flow of a different asset. The purpose of such a swap is to manage risk, to obtain funding at a more favorable rate than would be available through other means, or to speculate on future differences between the swapped cash flows.

## How Is a Swap Structured?

A swap is a derivative product that typically involves two counterparties that agree to exchange cash flows over a certain time period, such as a year. The exact terms of the swap agreement are negotiated by the counterparties and are then formalized in a legal contract. These terms will include precisely what is to be swapped and between whom, the notional amount of the principal, the maturity of the contract, and any contingencies. The cash flows that are ultimately exchanged are computed based on the terms of the contract, which may involve an interest rate, index, or other underlying financial instrument.

## Who Uses Swaps?

Swaps are mainly used by institutional investors such as banks and other financial institutions, governments, and some corporations. Their intended use is to manage a variety of risks, such as interest rate risk, currency risk, and price risk.

## Are Swaps Regulated?

Today, many swaps in the United States are regulated by the [Commodity Futures Trading Commission (CFTC)](https://www.investopedia.com/terms/c/cftc.asp) and sometimes the Securities and Exchange Commission (SEC), even though they usually trade over the counter (OTC). Due to the Wall Street reforms in the 2010 Dodd-Frank Act, swaps in the U.S. must use a [Swap Execution Facility (SEF)](https://www.investopedia.com/terms/s/swap-execution-facility-sef.asp), which is an electronic platform that allows participants to buy and sell swaps pursuant to regulation. The regulation of swaps is aimed at ensuring that these financial instruments are traded in a fair and transparent manner, and to reduce the risk of systemic financial failure (since swaps were blamed, in part, for the 2008 financial crisis). The specific regulations that apply to swaps internationally vary by jurisdiction.

## The Bottom Line

Swaps are derivative contracts that allow two parties to exchange cash flows or assets, typically between businesses or financial institutions, over the counter. Interest rate swaps, the most common type, involve exchanging fixed and variable interest rate payments based on a notional principal, enabling parties to hedge against or speculate on interest rate fluctuations. These financial instruments are complex and usually not accessible to retail investors, primarily serving purposes such as managing risk or speculating on financial movements.

> **Article Sources**
>
> 1.  U.S. Commodity Futures Trading Commission. “[CFTC Swaps Report Data Dictionary](https://www.cftc.gov/sites/default/files/idc/groups/public/@swapsreport/documents/file/propdatadict.pdf),” Pages 1–5.
>     
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> 3.  ICE. “[LIBOR®](https://www.ice.com/iba/libor).”
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> 4.  Federal Reserve Bank of New York. “[SOFR Averages and Index Data](https://www.newyorkfed.org/markets/reference-rates/sofr-averages-and-index).”
>     
> 5.  U.S. Commodity Futures Trading Commission. “[CFTC Swaps Report Data Dictionary](https://www.cftc.gov/sites/default/files/idc/groups/public/@swapsreport/documents/file/propdatadict.pdf),” Page 12.
>     
> 6.  The State Council of the People’s Republic of China. “[China, Argentina Renew Currency Swap Deal](https://english.www.gov.cn/news/202306/10/content_WS6483b2d7c6d0868f4e8dcbc6.html).”
>     
> 7.  Board of Governors of the Federal Reserve System. “[FOMC Statement: Federal Reserve, European Central Bank, Bank of Canada, Bank of England, and Swiss National Bank Announce Reestablishment of Temporary U.S. Dollar Liquidity Swap Facilities](https://www.federalreserve.gov/newsevents/pressreleases/monetary20100509a.htm).”
>     
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>     
> 9.  Stulz, René M. “[Credit Default Swaps and the Credit Crisis](https://cpb-us-w2.wpmucdn.com/u.osu.edu/dist/0/30211/files/2017/01/credit-default-swaps-and-the-credit-crisis-108ojj4.pdf).” _Journal of Economic Perspectives_, vol. 24, no. 1, Winter 2010, pp. 73–92.
>     
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>      
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