Types of Swaps

Swaps are financial derivative contracts that enable two parties to “swap” financial transactions, cash flows or payments related to an underlying asset periodically or at intervals. There are many types of swaps but below well cover the most popular ones. Many companies around the world use swaps as a way to hedge and minimize operational risks that they may face. There are different types of swap agreements but the most common ones that you’ll run into are interest rate, currency, commodity and equity swaps, discussed below.

The Swaps Market

Unlike options or futures, swaps do not trade on a standardized exchange but rather are contracts negotiated between parties in the over-the-counter market. (OTC) The contracts are “tailor-made” and details would vary based on what the parties are looking to accomplish. Swaps specialist would fill the role of the broker and/or market maker which are typically large institutions such as banks. Parties who enter into a swap contract do so because they want;

• Effectively manage risk – Swaps allow parties to change the timing & profile of cash flows related to the underlying asset.

Example: GRS Company owns 1,000,000 in fixed rate bonds earning 6% annually which is $60,000 in cash flows per year. 

GRS thinks that the interest rates will rise to 10%, which would generate $100,000 in cash flow yearly, ($40,000 more per year than the current bond holdings) 

GRS approaches a swap broker with the intention of swapping cash flows. 

They agree to give the swap broker $60,000 in fixed rate annual cash flows but in return, the swap broker provides them with cash flow generated from variable rate bonds worth $1,000,000.

The swap broker and the company would continue to exchange these cash flows until maturity date of the contract.


• Arbitrage – Parties entering into a swaps contract might be doing so in order to take advantage of price differentials.

• Access to new markets – Companies looking to gain exposure to certain markets may use swaps to do so. For example, a Canadian company can opt to enter into a currency swap with a European company in order to access more attractive CDN/EUR exchange rate because a European based financial firm can borrow domestically at a lower rate.

Common Types of Swaps

Below we’ve listed the most popular types of swaps that companies may engage in throughout the financial world.

Interest Rate Swap

A interest rate swap is when two parties agree to exchange streams of interest payments, over a certain period of time. The most common type of interest rate swaps are fixed-for-floating interest rate swaps. These types of swaps are known as vanilla swaps and are the most liquid interest rate swaps.

Example of a Interest Rate Swap:

Bank A, a fixed rate payer, buys a 8% swap with a $100,000 notional. The counter party is the Swap Dealer who deals with a floating rate, 6-month LIBOR which is currently 7%. The payment frequency will be semi-annually.  

Every six months, Bank A who is the fixed rate payer pays 4M USD to the Swap Dealer. (100M * 0.08/2) In return, the Swap Dealer would pay 3.5M. (100 * 0.07/2) The difference is 0.5M which Bank A pays to the Swap Dealer. If the LIBOR rate goes up, so will the payment to the bank.

Currency Swap

A currency swap involves when two or more companies exchange principal and interest payments, denominated in different currencies. These types of swaps are a popular way for companies to obtain financing at a lower interest rate in a country that they’re looking to do business in. Local companies are known to obtain lower and better financing in comparison to international companies.

For example, a US company is looking to establish a presence in Japan. This presence will cost $10 million dollars which is equivalent of $1 billion yen. The company is looking to obtain this amount in a form of a loan from the US markets with the goal of exchanging the amount with a Japanese company who is looking to obtain US currency. By swapping loan terms, these companies are able to achieve competitive rates and work together to limit foreign exchange risk.

Equity Swap

An equity swap is a derivative contract that allows two parties to exchange future cash flows with one another. These types of swaps have two legs; an interest rate leg that is usually tied to LIBOR and an equity leg that’s tied to a return of a stock or market index. Common indices are the Standard & Poor’s 500 Index, Dow Jones Industrial Average and the New York Stock Exchange.

For example, a hedge fund enters into a 3 year equity swap. Every three months, the hedge fund has to pay the average of S&P 500 return in exchange of the 90 day Libor rate.

Equity swaps are popular as they allow the parties to limit transaction costs that may be associated with equity trades. Parties are able to avoid margins and capital controls while being able to keep their equity position without equity risk.

Commodity Swap

A commodity swap allows two parties to swap cash flows which are dependent on the price of an underlying commodity such as gold, silver, corn, etc. These types of swaps have a fixed component and a variable component. One party pays a fixed commodity price while the other pays a variable price. In comparison to futures commodity contracts, cash settlement is the norm for these types of swaps.

The majority of commodity swaps involve oil with airlines and rail companies being the biggest utilizers. For example, American Airline enters in a 3 year fuel oil swap because they believe that the oil prices will be volatile in the next three years. The swap agreements states that every three months, the airline would receive the average market price based on a negotiated price quote and in return would pay a fixed price to the swap dealer.