What are swaps?

With a swap, you exchange future cash flows with another investor (usually in the same currency – that’s also called a plain vanilla swap).

For example, you could exchange interest rates. Let’s assume you feel that the interest rate will decrease while another investor wants to secure himself against rising interest rates. Therefore you might want a variable interest rate and the other investor wants a fixed rate.

Key Facts

1) Period between the swap payments (eg. interest payments) = Settlement period

2) The remaining duration before a swap expires is called = tenor

3) Date on which the two payments are exchanged = Settlement date

4) On the settlement date (usually) only the difference between the two payments is exchanged (in cash) -> this is also called netting

Another example of a very common kind of swap is a CDS (credit default swap). A CDS is like an insurance against a default of a bond issuer. Frequently even an insurance company issues these CDS. In that way, the insurance company offers an insurance on the bond issuer’s debt (against the default of the bond issuer) to the investor. For that insurance, the bondholder pays eg. 0.01 % of the bond interest to the insurance company.