What are Swaps? Definition, Meaning and How They Work

Those who operate in the stock market know that derivative instruments play a crucial role in risk management and in optimizing investment strategies. Among these, swaps certainly stand out, fundamental agreements that allow financial institutions, companies and investors to exchange cash flows or financial assets according to pre-established terms.

But why is it so important to know them? Obviously, for the use that is made of them and for the growing importance that these derivatives have acquired in recent decades in global financial markets, hand in hand with the increase in complexity and variants. All this so as not to compromise efficient financial management, of any nature.

As we will see, swaps allow you to mitigate specific risks, such as fluctuations in interest rates or currencies, and to access arbitrage and speculation opportunities. Here, then, is a detailed overview of swaps: let’s explore their definitions, the different types, the practical applications and the possible investment methods.

What are swaps in finance: meaning and definition

In the financial field, it is possible to give a precise and general definition for this instrument:

a swap is a derivative contract through which two parties agree to exchange cash flows or financial assets at pre-established future dates, according to specific terms. The term "derivative" indicates that the value of the swap is derived from an underlying asset, which may include interest rates, currencies, raw materials or other financial instruments.

Swaps are mainly used to manage the risk associated with changes in financial markets, allowing the parties involved to obtain more favorable conditions or to protect themselves from unfavorable fluctuations.

The structure of a swap generally involves the exchange of cash flows between the two counterparties. For example, in an interest rate swap, one party may agree to pay a fixed interest rate in exchange for a floating rate paid by the other party. This type of agreement allows the parties to change their interest rate exposure without having to alter their existing debt or credit positions.

Swaps are customizable instruments, which means that the terms of the agreement can be tailored to the specific needs of the parties involved. However, this flexibility also brings with it greater complexity than other standardized financial instruments. It is important to note that, as over-the-counter (OTC)->article1264] contracts, swaps are not traded on regulated markets, which leads to higher counterparty risk.

And from a regulatory perspective? Swaps are subject to specific regulations that vary by jurisdiction. For example, in the United States, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) regulate various aspects of swaps, while in Europe regulation is entrusted to the European Securities and Markets Authority (ESMA). All regulations aim to ensure transparency and reduce the systemic risk associated with these complex instruments.

The main types of swap contracts and how they work

But not all swaps are the same. We have talked about complexity and variations and, precisely for this reason, in finance there are different types of swaps that identify various facets. Each type is designed to meet specific risk management or investment needs. Here are the main categories of swaps to know and recognize, with some useful examples to understand how they work.

Interest Rate Swap (IRS)

Interest Rate Swaps are among the most common swaps and involve the exchange of cash flows based on interest rates. In a typical IRS one party pays a fixed interest rate, while the other party pays a variable rate, usually tied to a benchmark such as LIBOR or EURIBOR. This type of swap is primarily used to manage interest rate exposure.

• Example: A company with a variable rate loan could enter into an IRS to pay a fixed rate and receive a variable rate, thereby stabilizing its interest costs.

Currency Swap

Currency Swaps involve the exchange of principal and interest in two different currencies. The parties agree to exchange interest payments in different currencies and, at the end of the contract, return the initial principal exchanged. These swaps are used to manage currency risk and to obtain financing in foreign currencies on more favorable terms.

• Example: A European company that needs U.S. dollars could exchange euros for an American company that needs euros, with each party paying interest in the currency received.

Commodity Swaps

Commodity Swaps involve the exchange of cash flows linked to the price of a commodity, such as oil or natural gas. Typically, one party pays a fixed price for the commodity, while the other pays a variable price based on the market. These swaps are used by producers and consumers of commodities to protect themselves from price fluctuations.

• Example: An airline might use a commodity swap to fix the price of fuel, paying a fixed price and receiving payments based on the market’s changing price.

Credit Default Swap (CDS)

Among the most popular swaps, Credit Default Swaps are derivative instruments that act as insurance against the risk of default by an issuing entity, such as a company or government. In a CDS, the buyer of the contract pays periodic premiums to a seller (usually a bank or financial institution) in exchange for protection against the default of the underlying debt.

• Example: An investor who holds bonds issued by a company with a high risk of default can buy a CDS to protect themselves from the risk of default. If the company goes bankrupt, the CDS seller pays the investor a predetermined amount to compensate for the loss.

CDS have been widely used in global financial markets, but have also attracted controversy, especially after the 2008 financial crisis, when they were accused of amplifying systemic risk.

What are swaps for?

We have already discussed why and how swaps are used, but if we were to focus on the different financial purposes, we could summarize the most important ones in four macro areas.

Financial risk management

• Companies and financial institutions use swaps to hedge against risks related to interest rates, exchange rates and commodity prices. For example, a company with floating rate debt may want to lock in its financing costs through an Interest Rate Swap.

Arbitrage and Speculation

• Institutional investors use swaps to exploit arbitrage opportunities between different markets. For example, if the interest rate in one country is lower than in another, a trader could use a currency swap to borrow in the low-interest currency and invest in the high-yielding currency, earning a profit.

Optimizing Corporate Financing

• Many businesses use currency swaps to obtain cheaper financing. If a European company wants to finance itself in US dollars but does not have direct access to favorable rates, it can swap bonds with an American company that wants to obtain euros at lower rates.

4 Credit Risk Hedging

• Credit Default Swaps allow investors to protect themselves from the risk of default on bonds or loans in their portfolio. Banks, for example, use CDS to reduce their exposure to risky credits.

How and where to invest in swaps?

Investing in swaps is not easy for a retail investor, as these instruments are often reserved for institutional operators. However, there are several ways to access them.

1. Over-the-Counter (OTC) Market: As anticipated, swaps are traditionally traded on OTC markets, i.e. through private contracts between financial institutions, hedge funds and large companies. Due to their customization, these contracts are not standardized and can have significant counterparty risk.
2. Regulated trading platforms: After the 2008 crisis, many jurisdictions have imposed the centralized clearing of certain types of swaps to reduce counterparty risk. There are now platforms such as Swap Execution Facilities (SEF) in the United States, regulated by the CFTC, that allow certain swaps to be traded more transparently.
3. ETFs and mutual funds: Some investment funds use swaps to replicate the performance of specific indices or assets. For example, swap-based ETFs use swap contracts with financial institutions to gain exposure to a market index without directly purchasing the underlying securities.
4. Exchange-traded derivatives: For retail investors, the most accessible form of swap investing may be through standardized derivatives, such as futures and interest rate and currency options, which can offer similar exposure to swaps but with greater transparency and lower counterparty risk.

Original article published on Money.it Italy. Original title: Cosa sono gli swap? Definizione, significato e funzionamento