What Are Swaps in Finance and How Do They Work?

Introduction

A swap is a contract where two parties agree to exchange cash flows in the future. These cash flows usually come from interest rates, currencies, or commodities. The terms are agreed upon today, and payments happen on fixed dates later.

Swaps often use a notional amount (a reference number used for calculations). In most interest rate swaps, the notional is not exchanged. In currency swaps, principals in two currencies are exchanged at the start and end.

Companies, banks, and investors use swaps to manage risks, change loan structures, or gain exposure without directly buying assets. This guide covers the meaning, types, working process, risks, pricing basics, and real-world examples.

What is a Swap in Finance?

A swap is a deal to exchange cash flows based on predefined rules. The contract specifies:

• Notional: Base number for calculations
• Tenor: Total duration of the swap (e.g., 3 or 5 years)
• Reset date: When the floating rate is updated
• Payment date: When cash flows are exchanged
• Legs: Each side of the payment (fixed leg vs floating leg)
• Netting: If in the same currency, only the difference is paid

Types of Swaps

1. Interest Rate Swap

• One leg pays a fixed rate, the other pays a floating rate (e.g., 3-month LIBOR).
• Used to convert floating rate loans into fixed or vice versa.

2. Currency Swap

• Exchange of both principal and interest in two currencies.
• Helps companies match cash flows to their reporting currency.

3. Cross-Currency Interest Rate Swap

• Combination of both: principal exchanged in two currencies, with fixed or floating interest payments.

4. Commodity Swap

• Payments linked to commoditieslike oil or gas.
• One party pays a fixed price, the other pays market-linked floating price.

5. Equity or Total Return Swap

• One party pays returns from a stock/index.
• The other pays a funding rate.
• Allows exposure without owning the stock directly.

6. Inflation Swap

• One leg pays a fixed rate.
• The other pays returns linked to inflation.
• Used to manage real cash flow risks.

Note: Credit Default Swaps (CDS) are another type, but advanced and not covered in detail here.

Table: Summary of Swap Types

Swap Type

What is Exchanged

Purpose/Use Case

Interest Rate Swap

Fixed vs Floating interest payments

Hedge against rising or falling interest rates

Currency Swap

Principal + interest in two currencies

Manage currency exposure, access cheaper loans

Cross-Currency Interest Swap

Interest in two currencies (fixed/floating)

Combine interest & currency management

Commodity Swap

Fixed vs floating commodity prices

Manage risk of volatile commodity prices

Equity/Total Return Swap

Stock/Index returns vs funding rate

Gain exposure without direct ownership

Inflation Swap

Fixed rate vs inflation-linked payments

Protect against inflation in cash flows

Read more: What Are Swap Derivatives

How an Interest Rate Swap Works

1. Two parties agree on a notional value (e.g., ₹10 crore).

2. They fix a tenor (e.g., 3 years).

3. Payment frequency is set (e.g., every 3 months).

4. One side pays a fixed rate (say 6%).

5. The other side pays a floating rate (say 3-month market rate).

6. At each reset:

   • Calculate fixed and floating payments.
   • Net the difference (only pay the excess).

Example

• Notional: ₹10,00,00,000
• Tenor: 1 year (quarterly payments)
• Fixed rate: 6.0%
• Floating rate (Quarter 1): 5.2%
• Fixed payment = ₹15,00,000
• Floating payment = ₹13,00,000
• Net = Fixed payer pays ₹2,00,000

In later quarters, if floating > fixed, the net flips. This allows a firm with floating loans to effectively pay a fixed cost.

How a Currency Swap Works

1. Two firms (A and B) need funds in each other’s currency.
2. They borrow cheaply in their own market.
3. Exchange principals at an agreed rate.
4. During the life of the swap, each pays interest in the other’s currency.
5. At maturity, principals are swapped back.

Example

• Firm A borrows ₹80 crore (rupees).
• Firm B borrows $10 million (dollars).
• They exchange at rate 1 USD = ₹80.
• During swap: A pays $ interest, B pays ₹ interest.
• At end: swap back $10 million and ₹80 crore.

Why Do Firms Use Swaps?

• Hedge Interest Rate Risk: Convert floating loans to fixed.
• Hedge Currency Risk: Match inflows and outflows in the same currency.
• Lower Funding Cost: Borrow where cheaper, then swap into needed form.
• Match Assets & Liabilities: Align payments with revenues.
• Change Exposure: Keep original deal but overlay swap.
• Access Exposure: Gain exposure to equities or commodities without direct purchase.

Risks in Swaps

1. Counterparty Risk

Other side may default. Clearinghouses/collateral reduce risk.

2. Market Risk

Rates or prices may move against you.

3. Basis Risk

Your real-world cash flows may not perfectly match swap terms.

4. Liquidity Risk

Some swaps are hard to price or exit.

5. Legal & Operational Risk

Errors in contracts or systems can cause losses.

6. Early Termination Risk

Ending early may require costly settlement.

7. Complex Product Risk

Equity, commodity, or credit swaps may be harder to understand.

Comparison Table: Benefits vs Risks of Swaps

Benefits of Swaps

Risks of Swaps

Manage interest rate risk

Counterparty may default

Manage currency risk

Market movements may go against you

Lower funding costs

Basis risk due to mismatch

Align assets & liabilities

Liquidityissues in some swaps

Change payment structure without new loan

Legal/operational risks

Gain exposure without owning asset

Early termination costs

Basics of Swap Pricing

• On day one, the fixed rate is set so present value of fixed = present value of floating.
• Floating resets each period, so starts near notional.
• Market movements later create gains/losses.
• For currency swaps: pricing depends on yield curves and spot FX rate.

How to Enter a Swap Safely

1. Define your goal (hedge, exposure, funding).
2. Choose a swap type (interest, currency, etc.).
3. Set notional, tenor, reset, and payment terms.
4. Compare quotes from dealers.
5. Check clearing/agreements for margin needs.
6. Run stress tests (+/–1% rate moves).
7. Keep buffer cash for margin calls.
8. Track resets, payments, and mark-to-market value.

Conclusion

Swaps are powerful tools to manage risks and cash flows. They allow firms to adjust interest rates, currencies, or exposure without changing original contracts. However, swaps carry counterparty, market, and complexity risks. Beginners should start small, understand terms well, and use them only for clear, practical goals.