Why swap matters
Swaps can transform risk and funding efficiently without transferring the underlying asset. They introduce counterparty, collateral, valuation, basis, liquidity, and legal risks.
How it is applied
Parties define notional, payment legs, dates, indices, day count, collateral, termination, netting, and governing documents. Exposures are marked and stress-tested. Define the two payment legs, notional, reference index, reset dates, maturity, collateral, counterparty, termination, and clearing. Value the difference between expected future legs using appropriate curves. Risk reporting should include sensitivities, notional, replacement value, collateral, and stress exposure.
Portfolio example
In an interest-rate swap, one party pays 4% fixed on $10 million and receives a floating rate. Notional sets payments but is not exchanged in a standard contract. In a five-year interest-rate swap, one party pays fixed 4% and receives a floating benchmark on 10 million notional. If floating resets to 5%, the receiver earns a positive net payment for that period before day count and valuation changes.
How to interpret it
Swap value changes as expected cash flows and discount rates change. A hedge works only when contract and underlying exposure remain aligned. Swaps exchange specified economic exposures without necessarily transferring principal. They can hedge rates, currency, credit, commodities, or total return. Market value changes as expectations and spreads move, even when current net cash payment is small.
Limitations and common misconceptions
Over-the-counter terms can be complex. Counterparty default, benchmark reform, collateral calls, early termination, and basis can cause loss. Notional is not the same as value at risk, but leverage can be substantial. Counterparty failure, collateral calls, basis, model curves, documentation, early termination, and liquidity affect outcomes. Cleared swaps reduce some bilateral risk while introducing clearing-member and margin dependencies. Before execution, compare the swap with cash securities and futures on all-in cost, liquidity, collateral, accounting, and termination flexibility. A swap can avoid immediate asset purchase yet create concentrated counterparty and funding exposure. Independent valuation is especially important when bespoke terms make dealer quotations difficult to compare or exit. Confirm governing law, valuation agents, and dispute procedures.
Sources and further reading
- Futures GlossaryU.S. Commodity Futures Trading Commission
- Introduction to DerivativesCFA Institute