Strategic Financial Management · Swaps

Introduction to Swaps and the Swap Market

Updated 11 October 2026 · Fact-checked

A swap is an agreement between two parties to exchange streams of cash flows over a set period, based on an agreed notional amount. Companies use swaps to change interest rate or currency exposure. To answer questions, identify the parties, the cash flows exchanged, the notional, and the risk being managed.

Understand Introduction to Swaps and Swap Market

A swap is a contract in which two parties agree to exchange cash flows on future dates. The cash flows are calculated on an agreed notional principal. The notional is usually not exchanged in an interest rate swap. It only decides the size of the payments.

Why do swaps exist? Different firms borrow on different terms. One firm may get cheap fixed-rate funds, but want a floating-rate liability. Another firm may be in the opposite position. A swap lets each firm change the nature of its liability or asset without repaying the original loan. This is the idea of comparative advantage: each party borrows where it is relatively cheaper and then swaps.

Swaps are over-the-counter (OTC) contracts. They are privately negotiated, so terms can be tailored: amount, tenor, payment dates, rate basis. This flexibility is the main strength. The cost is counterparty (credit) risk: the other side may default. Unlike exchange-traded futures, there is no daily margining by an exchange in the basic form.

The main participants are end users (corporates, banks, financial institutions, governments) who swap to manage risk or reduce cost. Swap dealers (usually banks) quote bid and offer rates and take the opposite side, earning the spread. They then hedge or match their own book. Swap brokers only find counterparties and earn a commission. They do not take the position themselves. Dealers and brokers differ on this one point: a dealer is a principal, a broker is an agent.

The swap market began in the early 1980s with currency swaps, followed by interest rate swaps. It grew because of volatile rates and exchange rates, and because of global borrowing. Common types are interest rate swaps, currency swaps, and others such as commodity and equity swaps. Each type is studied in detail in later topics.

Key rules to remember

Net payment in a plain interest rate swap: Net payment = Notional × (Fixed rate − Floating rate) × (days ÷ year basis); Fixed-rate payer pays this if the result is positive and receives it if negative. Only the net amount is exchanged on each date.
Total gain from a swap (comparative advantage): Total gain = (Difference in fixed-rate spread) − (Difference in floating-rate spread); Take the absolute difference between the two firms' spreads in each market. The gain is then shared between the parties and the dealer, if any.
Dealer's earning: Dealer's spread = Offer rate − Bid rate; A dealer is a principal and earns the spread. A broker earns a commission instead.

How to solve Introduction to Swaps and Swap Market questions

Use this method for any theory or short numerical question on swaps and the swap market.

1Identify the two parties and what each wants: fixed or floating, one currency or another.
2State the type of swap and the notional principal. Say whether the notional is exchanged.
3List the cash flows each party pays and receives, with dates and rate basis.
4Name the risk being managed (interest rate, currency) and any new risk created (counterparty risk).
5If an intermediary is involved, state whether it acts as a dealer (principal) or broker (agent) and how it earns.
6For numbers, compute each party's net payment or the total gain using the formula, then split the gain as stated.
7Check that the net effective cost for each party is correct and end with a clear conclusion.

Quickest way: Four-line swap check

When to use it: Use this for MCQs and for the opening lines of a descriptive answer when time is short.

Ask: is the contract an exchange of cash flows on a notional? If yes, it is a swap.
Notional is only a reference in interest rate swaps. Do not add it to the payments.
Dealer takes the position and earns the spread. Broker only introduces and earns a commission.
Swaps are OTC and customised. Their key risk is counterparty default.

Common mistakes in Introduction to Swaps and Swap Market

Saying the notional principal is paid or received in an interest rate swap.
Students mix swaps with loans or with currency swaps.
Fix: In a plain interest rate swap only interest amounts, usually netted, are exchanged. Principal exchange belongs to currency swaps.
Treating a swap broker and a swap dealer as the same.
Both are intermediaries and the words sound alike.
Fix: A dealer is a principal that takes the opposite side and earns the bid-offer spread. A broker is an agent that matches parties for a commission.
Calling swaps exchange-traded contracts like futures.
All are derivatives, so students assume the same trading mechanism.
Fix: Swaps are OTC, privately negotiated and customised. Mention counterparty risk as the result.
Assuming a swap removes all risk.
Swaps are taught as hedging tools.
Fix: A swap changes the risk. It hedges rate or currency exposure but creates credit risk on the counterparty.
Computing swap gain using the wrong spread differences.
Students subtract spreads in the wrong order or mix fixed and floating.
Fix: Find the spread gap in each market separately, then take the difference of the two gaps.

Worked examples

Example 1

Firm A can borrow fixed at 9% or floating at MIBOR + 1%. Firm B can borrow fixed at 10.5% or floating at MIBOR + 1.5%. Find the total gain available from a swap between them.

Show the solution

Fixed-rate spread difference: 10.5% − 9% = 1.5%.
Floating-rate spread difference: (MIBOR + 1.5%) − (MIBOR + 1%) = 0.5%.
Total gain = 1.5% − 0.5% = 1.0%.
A has an advantage in both markets, but a bigger one in fixed. So A should borrow fixed and B floating, then swap.

Answer: The total gain from the swap is 1.0% per annum. It is shared between A and B (and a dealer, if one is used) as agreed.

Example 2

A company has a ₹50,00,000 notional swap in which it pays fixed 8% and receives floating. For one half-year period (take it as exactly half a year) the floating rate is 9%. Find the net settlement.

Show the solution

Fixed payment = ₹50,00,000 × 8% × 0.5 = ₹2,00,000.
Floating receipt = ₹50,00,000 × 9% × 0.5 = ₹2,25,000.
Net = ₹2,25,000 − ₹2,00,000 = ₹25,000 in favour of the company.
Only this net amount is paid by the counterparty. The notional is not exchanged.

Answer: The company receives a net ₹25,000 for the period.

Exam tips

Write definitions in one line, then features as short points: OTC, customised, notional, counterparty risk.
Always distinguish dealer and broker in a sentence of its own. Examiners ask this directly.
In numerical questions, show the fixed and floating legs separately before the net figure.
Link the swap to the risk it hedges. A bare definition earns fewer marks than an application to a case.

Practice questions from Swaps

Introduction to Swaps and Swap Market in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Introduction to Swaps and Swap Market: frequently asked questions

What is a swap in simple words?

A swap is a contract where two parties exchange cash flows on future dates, based on an agreed notional amount. It is used to change exposure to interest rates or currencies.

What is the role of a swap dealer?

A swap dealer, usually a bank, quotes bid and offer rates and enters the swap as a principal. It earns the spread and manages its own risk by matching or hedging its swap book.

Are swaps traded on an exchange?

Basic swaps are OTC contracts negotiated privately between parties. That is why they can be customised, but also why counterparty risk matters.

How is a swap different from a forward contract?

A forward is a single exchange on one future date. A swap is a series of exchanges on several dates, and can be seen as a package of forwards.