Over-the-counter contracts between financial institutions whereby two firms will exchange the liability from two differing financial instruments.
A swap is a type of derivative. Derivatives have no intrinsic value of their own; instead, their value is “derived” from, or based on, some underlying investment or agreement. For example, a derivative may make greater payments as interest rates on a debt obligation increase.
While some investors use derivatives to make money, governments typically use them to hedge against risk, or protect from future uncertainty and changes in the market. Governments may also use derivatives to try to lower their borrowing costs. Some laws require swaps to be connected with debt issues and there is no authority to enter into purely speculative swaps.
In a swap agreement, two parties “swap” payments or some type of financial instrument. Generally, retail investors – households and individuals – do not enter into swap agreements. Instead, swap dealers, such as banks and insurance companies, make up most of the swap market. To help evaluate the complexities of swap agreements, governments and other purchasers tend to hire a swap advisor.
Interest rate swaps are the most common type of derivative for governments. A government may issue variable rate bonds linked to a specific index – the bonds may pay the one-year LIBOR rate, plus 25 or 50 basis points, for example. In a floating-to-fixed-rate swap, the government “swaps” the variable rate interest payments with another party (the counterparty) and essentially converts the variable rate debt to fixed rate debt. The government makes unchanging, fixed payments for, say, the equivalent to 4 percent interest on the bonds’ principal amount to the counterparty on schedule with interest payments. The counterparty pays the government a variable amount equal to the interest payments on the debt, which fluctuates over the life of the agreement.
The International Swap and Derivatives Association (ISDA), a trade association, has developed the ISDA master agreement to help govern swap transactions. While parties to swap agreements still negotiate the various financial terms – rates, prices, and maturities, for example – the ISDA master agreement sets general conditions regarding defaults and events that may end swap agreements early, among other things.