What are SWAPs Contracts and Different Types of SWAPS?

A Swap is a financial derivative that allows two parties to exchange liabilities or revenue streams from two underlying assets with opposing characteristics. Usually, Swaps involve a fixed cash flow stream and a variable cash stream.

Swaps are over-the-counter derivates that are arranged directly by two parties. These instruments do not trade like other marketable securities on exchanges. Swaps work well for two parties if they carry financial instruments with opposing characteristics such as a fixed and a variable interest rate loan.

What is a Swap Contract?

A Swap is a contract between two parties to exchange or “swap” cash flows arising from an underlying asset held by each party. These underlying assets can be any financial instrument or commodity. The most commonly used instruments in swaps are bonds, loans, commodities, and currency pairs.

How Does a Swap Contract Work?

In a swap contract, the principal amounts do not exchange. Both parties only exchange the net cash flows arising from the contract at the actual date. A swap involves one part of fixed cash flows (for equal amounts) and another for variable cash flows.

Both parties only exchange the net of variable cash flows after adjustments. These cash flow adjustments can be a one-off settlement or a series of cash payments for a defined period.

Swap contracts allow both parties to exchange variable cash flows of two similar instruments. For instance, two parties can agree on exchange the interest rate payments for an equal amount of loans with variable and fixed-rate loans. Similarly, two parties in different countries can create a currency swap predicting opposite currency movements.

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Different Types of Swaps

There are different types of swaps. Swaps can be customized according to the needs of both parties. Interest rate and currency swaps are commonly used OTC contracts.

Interest Rate Swaps

Suppose a company ABC has a floating-rate bank loan of $ 1 million with a 5-year term. The interest rate is 2% base + LIBOR. Assume the current LIBOR rate is 2%. The company ABC predicts an increase in the LIBOR and the total cost of borrowing in the coming years.

The company ABC looks for an interest rate swap with another company XYZ. The company XYZ has a fixed interest rate loan of $1 million with the same term. It comes with a fixed interest rate of 5%. Both companies enter into an interest rate swap. Now the company ABC will receive the fixed interest rate payments with a 5% rate and will pay the variable interest rate payments to XYZ instead of the bank.

Let’s assume the company ABC predicted correctly and LIBOR increased 0.75% yearly.

Year LIBOR + 2% ABC Receives ABC Pays NET +/-
Year 14%$ 40,000$ 50,000-$ 10,000
Year 24.75%$ 47,500$ 50,000-$ 2,500
Year 35.5%$ 55,000$ 50,000+ $ 5,000
Year 46.25%$ 62,500$ 50,000+ $ 12,500
Year 57.0%$ 70,000$ 50,000+ $ 20,000
Total   + 25,000

The observed scenario worked well for the company ABC by entering into an interest rate swap. However, if the management didn’t predict well and interest rates do not rise or not significantly, they would lose money. Suppose, if the interest rates increase yearly only by 0.25%. Then, the net cash flow for the company ABC would have been – $ 25,000.

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Currency Exchange Swaps

Suppose both companies in the above example operate in the US (ABC) and UK (XYZ) respectively. ABC receives revenue in GBP by doing business in the UK, whereas XYZ receives in USD. Both companies predict currency exchange movement and want to hedge against the risk. They enter into a currency swap with the following details.

Current exchange rate:  £1: $ 1.25              

ABC receives: £ 5 million or $ 6.25 million.

If the exchange rate falls to £1: $ 1.20 then, ABC receives $ 6.0 million.

With a swap contract with XYZ, the company ABC will receive $ 6.25 million irrespective of the currency exchange movement.

ABC has hedged against the adverse currency exchange movement. However, it has also foregone the potential benefit of favorable currency movement. Suppose, XYZ predicted correctly this time and currency exchange rates moved from 1:1.25 to 1: 1.30, then:

ABC would have received: $ 6.50 million which is $ 25,000 more than it received with a swap.

Other Common Types of Swaps

Other commonly used swap derivates include:

  • Hybrid swaps
  • Commodity swaps
  • Zero-coupon swaps
  • Total return swaps

Pros and Cons of Using Swaps


Both parties can hedge against potential risks of changing price movements in an underlying asset. Cash flows from a fixed and variable source can be customized to create a mutually beneficial position through a swap contract.

Swaps are OTC instruments and can be arranged directly by two parties. Banks, financial institutes, and other third-party actors receive their commission and benefits regardless of the outcome for any party.


Swaps do not trade on exchanges like other derivates. Only one of the two or more parties can predict correctly and benefit from the arrangement.

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Both parties may forego the upside benefits with a swap contract.

Final Thoughts

Swaps are derivate instruments that are traded on OTC markets. These contracts can be customized and arranged directly by two parties. Swaps are effective in hedging currency and interest rate risks.

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