Deep Dive · Swaps · Lesson 1
What Is
a Swap?
Big Idea
A swap is an agreement between two parties to exchange a series of cash flows over time. Where a forward or a future is a single trade on one future date, a swap is a whole stream of exchanges, running for months or years. The most common kind trades a fixed interest rate for a floating one.
- A forward is one exchange on one date.
- A swap is many exchanges over time — a repeating schedule.
If a forward is a single payment, a swap is a subscription.
The Core Idea
Two parties agree to swap one set of payments for another on a set schedule. Each side’s payments are calculated from an agreed notional amount and a rule — for example, a fixed rate, a floating rate, or an amount in another currency. On each payment date, the two sides exchange what they owe.
For the most common swaps, the notional itself is never handed over — it is only the reference figure the payments are worked out from. What actually changes hands is the difference between the two sides’ payments.
A Simple Example
The classic swap is an interest rate swap. Company A has a loan whose rate floats up and down with the market, and it wants predictable payments. Company B is comfortable with a floating rate. So they agree to swap:
- Company A pays Company B a fixed rate.
- Company B pays Company A a floating rate.
- Company A uses the floating payment it receives to cover its floating loan — so its net cost is now effectively fixed.
Neither loan was refinanced. They simply swapped the kind of interest they each pay.
A Swap Is Like a Strip of Forwards
A helpful way to picture a swap is as a series of forwards bundled together. Each payment date is a small exchange at an agreed rate, much like a forward settling — and a swap simply lines up many of them, one after another, into a single contract. That is why the last lesson of the forwards course leads naturally here: a swap is what you get when you need to lock in not one future exchange, but a repeating stream of them.
The Main Types
Swaps come in a few common forms. The rest of this course takes each in turn.
| Type | What Is Exchanged |
|---|---|
| Interest rate swap | A fixed interest rate for a floating one (the most common swap) |
| Currency swap | Principal and interest in one currency for another |
| Credit default swap | Regular premiums for a payout if a borrower defaults |
Private and Over-the-Counter
Like forwards, swaps are over-the-counter — private, customised contracts arranged directly between two parties, usually a company and a bank, rather than bought and sold on an exchange. That makes them flexible, but it also means each side depends on the other to keep paying: swaps carry counterparty risk.
There is usually no premium to enter a plain swap. It is normally set up so that it is worth about zero to both sides at the start — fair to each — so no money changes hands until the first scheduled payment. (The credit default swap, later in this course, is the exception: its buyer pays an ongoing premium.)
Interactive Checks
Check 1 of 3
You are describing a swap to a friend.
Which description is correct?
Check 2 of 3
Someone asks you which kind of swap is the most common.
Which is it?
Check 3 of 3
You are comparing a swap with a forward contract.
How does a swap differ?
Common Beginner Mistakes
- ❌ Thinking a swap is a single trade. A swap is a stream of exchanges on a repeating schedule, not a one-off.
- ❌ Confusing the notional with money that changes hands. For an interest rate swap the notional is only a reference figure — it is never exchanged.
- ❌ Assuming swaps trade on an exchange. They are private, over-the-counter contracts and carry counterparty risk.
- ❌ Expecting to pay a premium. A plain swap starts at about zero value to both sides — the credit default swap is the exception.
Quick Memory Tool
- Swap = exchange a series of cash flows over time
- A forward is one exchange; a swap is many — like a strip of forwards
- Most common: the interest rate swap (fixed for floating)
- The notional is usually a reference figure, not exchanged
- Private and over-the-counter — no premium on a plain swap, but counterparty risk
Next Lesson
Interest Rate Swaps — the most common swap of all. Next we see how one side pays a fixed rate and the other a floating rate, and why a company would want to trade one for the other.