What are Swaps?

Swaps are derivative contracts through which two parties exchange the cash flows or liabilities from two different financial instruments. The most common type is an interest rate swap, but there are many other forms used across financial markets.

Swaps can be customized between parties (bilateral OTC), but post-2008 regulation has pushed many into Swap Execution Facilities (SEFs) for transparency and clearing.

Types of Swaps

How Swaps Are Traded

Swaps are primarily traded in the over-the-counter (OTC) markets, though increasing regulation has led to the development of more centralized platforms:

• Request For Quote (RFQ): Buyer sends quote request to multiple dealers.
• Order Book / Central Limit Order Book (CLOB): Rare in swaps, more common in cleared credit index swaps.
• Voice Brokered: For large trades or less liquid instruments.
• Swap Execution Facility (SEF): Regulatory structure in the U.S. for electronic execution of swaps.

Clearing through a Central Counterparty (CCP) is now common for standardized swaps, reducing counterparty risk.

Example: Interest Rate Swap (Fixed vs Floating)

• Notional: $10 million
• Fixed Leg: Pays 2.5% annually
• Floating Leg: Pays 3M SOFR + 50 bps
• Payment Frequency: Quarterly (floating), Annually (fixed)
• Maturity: 5 years

Only net cash flows are exchanged. If SOFR is 2.0%, floating pays 2.5% (2.0% + 0.5%), matching fixed. If SOFR (Secured Overnight Financing Rate, a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities) rises to 3.0%, floating pays 3.5%, and pays the difference to fixed.

Swap Pricing and Market Quotation

Swaps are priced based on the net present value (NPV) of future expected cash flows exchanged between the fixed and floating legs. The value of a swap at initiation is typically zero, meaning the present value of both legs is equal.

The general pricing formula is:

Where:

• ( PV_{ ext{Floating Leg}} ) is the present value of the expected floating payments, typically derived from a forward curve (e.g., SOFR forward rates)
• ( PV_{ ext{Fixed Leg}} ) is calculated using the fixed rate agreed in the contract and discount factors from the yield curve

The fixed rate that equates these present values is known as the par swap rate.

Market Quotation

Swaps are quoted by the fixed rate on the swap (e.g., "5-year USD swap at 3.15%"). The floating leg is usually indexed to a benchmark (e.g., 3M SOFR, EURIBOR), and market participants quote spreads above or below the par rate based on supply/demand and credit considerations.

Example:

A 5-year USD interest rate swap:

• Notional: $100 million
• Fixed Rate Quoted: 3.20%
• Floating Index: 3M SOFR (projected using forward curve)
• If the swap is at market, then: $$PV_{ ext{Fixed Leg}} = PV_{ ext{Floating Leg}}$$

If a bank offers the swap at 3.30%, it implies they believe floating rates will average less than 3.30% over the life of the swap.

Use Cases

• Hedging: Corporates use swaps to convert liabilities from fixed to floating or vice versa.
• Speculation: Hedge funds bet on rate curves, credit spreads, inflation expectations.
• Arbitrage: Exploit mispricing between swap curves and bond curves.

Regulatory Considerations

Post-2008 reforms under Dodd-Frank and EMIR:

• Mandatory clearing for standardized swaps.
• Reporting to trade repositories.
• Execution via SEFs (Swap Execution Facilities) or MTFs (Multilateral Trading Facilities).

Summary Comparison: Swap vs Bond