Swap
A swap is an OTC derivatives contract in which two counterparties agree to exchange sequences of cash flows based on different underlying references — most commonly, one party pays a fixed interest rate while the other pays a floating rate on the same notional principal.
The interest rate swap is the world's most widely used derivative instrument, with notional outstanding measured in hundreds of trillions of dollars globally. In a plain-vanilla interest rate swap, one party agrees to pay a fixed annual or semi-annual rate (the swap rate) on a notional principal amount while receiving a floating rate — typically SOFR in current U.S. practice — in return. The notional principal is never exchanged; only the net difference between the fixed and floating payments changes hands on each settlement date.
Swaps are used extensively for asset-liability management. A bank that has issued fixed-rate CDs to depositors but lends at floating rates can enter a pay-fixed, receive-floating swap to transform its interest rate exposure. A corporation that has floating-rate debt and prefers the certainty of fixed payments can enter a pay-fixed, receive-floating swap to lock in its borrowing cost. These are the canonical hedging applications that justify the existence of the swap market.
Following the 2008 financial crisis, U.S. swap market structure changed fundamentally under the Dodd-Frank Act. Standardized interest rate swaps must now be executed on Swap Execution Facilities (SEFs) and centrally cleared through regulated clearinghouses — primarily the CME Clearing and LCH — eliminating the bilateral counterparty credit risk that was a systemic concern in 2008. Non-standard or customized swaps may still be negotiated bilaterally under ISDA Master Agreement documentation.
In addition to interest rate swaps, the swap universe includes currency swaps (exchanging cash flows in two different currencies), total return swaps (exchanging the total return on an asset for a fixed or floating payment), equity swaps (synthetic equity exposure), and commodity swaps. Credit default swaps — a specific type of protection-buying swap — are covered separately given their unique role in credit markets.
The CME Group offers futures contracts on swap rates (DSF — Deliverable Swap Futures) that provide exchange-traded, centrally cleared access to interest rate swap economics, bridging the worlds of futures and OTC swaps.