Swaps: Interest Rate and Credit

A swap is an over-the-counter contract under which two parties exchange a series of cash flows over a specified period. Swaps are the largest segment of the global derivatives market: the notional volume of outstanding positions in interest rate swaps exceeds $400 trillion. The swap market is critically important for banks, corporations, and institutional investors in managing interest rate and credit risk.

An interest rate swap (IRS) is the most common type of swap. The classic “plain vanilla” IRS: one party pays a fixed rate, the other pays a floating rate (SOFR or Euribor). There is no exchange of principal—only of interest payments. Applications of IRS: a corporation with floating-rate debt hedges interest rate risk by locking in a fixed rate; a bank manages balance sheet interest rate risk through a receive-fixed IRS; an asset manager adjusts portfolio duration without buying or selling bonds. The fixed swap rate is set so that the NPV of the contract at inception equals zero.

A cross-currency swap differs from an IRS in that the parties exchange principal amounts in different currencies at the beginning and end of the term, as well as interest payments. It is used to raise financing in foreign currency, hedge currency risk for long-term investments, and arbitrage between capital markets of different countries.

A credit default swap (CDS) is a contract where the protection buyer pays a periodic premium (the CDS spread in basis points), and the protection seller compensates losses in the event of a credit event (default, debt restructuring). CDS is analogous to insurance against issuer default. Applications of CDS: a bank hedges credit risk of a corporate loan; an investor takes a short credit position without physically selling the bond. The 2008 crisis exposed systemic risks of CDS: AIG accumulated $440 billion notional CDS without adequate collateral.

Regulation of swaps changed drastically after the 2008 crisis: the U.S. Dodd-Frank Act and European EMIR mandated clearing of standardized swaps through central counterparties, introduced margin requirements for non-centrally cleared derivatives, and required reporting to trade repositories. Today, most interest rate swaps are cleared through LCH.Clearnet and CME Clearing.