Types of swaps

A swap is a financial contract between two counterparties in which a series of cash flows are exchanged in order to minimise the risk of holding an instrument or a certain exposure.

They are often used for risk management purposes, although swaps can be used by institutional asset managers to bet on the direction of a particular market.

Who uses swaps?
Governments in many countries use swaps to help manage risks associated with floating interest rates and foreign currency exposures.

Some companies use swaps to hedge their own interest rate and money market risks or future income streams.

Even some individuals and small businesses may find swaps useful tools for hedging or speculation.

Types of swaps
There are different types of swaps, but swaps generally involve two parties exchanging cash flows over an agreed period of time.

These cash flows usually depend on a reference rate or variable, and sometimes they are fixed between the two parties.

For example, an interest rate swap will see both parties exchange interest on a certain principal amount at a fixed rate and a variable rate for the same period.

In the event of a downward movement in interest rates, swaps can be used to lock in these lower fixed rates, while an upward trend can be hedged by using swaps to pay fixed rates and receive floating rates.

There are different types of swaps, including swaps where:

the principal is repaid in the same currency in which it was borrowed (e.g. an interest rate swap)
the principal is repaid in another currency (e.g. a multi-currency interest rate swap) or
swaps that involve two currencies but also have other features such as variable or fixed rates (for example, a total return index swap).

Let's look at the most common type of swap.

Interest rate swaps

A common type of swap is the interest rate swap (IRS), which refers to swaps involving bonds or interest payment receipts.

They involve two counterparties exchanging a stream of cash flows over an agreed period of time, based on one or more reference interest rates. Traditionally this has been a reference rate such as Libor (London Interbank Offered Rate), Euribor (Euro Interbank Offered Rate) or TBA - LIBOR (The Brokers Offered Rate).

Now that Libor is being phased out due to a series of rigging scandals, other interest rate references have been introduced in its place, such as SOFR.

They also generally involve the exchange of a final cash flow called a "termination payment" or "termination value" at a time determined by an agreed formula, by analogy with the final payment of the principal of a bond.

For example, Libor-based swaps may stipulate that if one party swaps variable rates with another and then swaps back to fixed rates in the future, it must swap back to the same rate as the original swap or to prevailing market rates.

These swaps can be used for hedging purposes, for example where companies use swaps to lock in interest rates for borrowings over various periods while protecting themselves from any significant rise or fall in interest rates.

Another important distinction is that an interest rate swap is an agreement between two counterparties to exchange cash flows that are based on a notional principal amount and one or more agreed-upon interest rates, denominated in a single currency. Those that are denominated in two different currencies - i.e. a multi-currency interest rate swap - are generally referred to as quantum swaps.

Cash flows relating to interest rate swaps may involve periodic interest payments at agreed intervals, such as quarterly, semi-annually or annually.

But the term "interest rate swap" can also refer to swaps where there is only one final value exchanged, often called an "accumulation swap".

Swaps involving multiple cash flow exchanges can be divided into two categories: those with a principal repayment leg and those without.

The latter may either have no final payment at maturity (a "bulleting swap") or may have a "balloon payment" at the end - usually calculated so that the present value of that payment equals the original notional principal amount.