Swap
A derivative contract where two parties exchange cash flows based on a notional principal amount.
What is Swap?
A swap is an OTC derivative contract in which two parties agree to exchange a series of cash flows over a set period based on a notional principal amount. The notional itself is rarely exchanged; only the cash flow streams change hands. The most common type is the plain-vanilla interest rate swap, where one party pays a fixed rate and receives a floating rate (typically SOFR or LIBOR). Other common swaps include currency swaps, which exchange payments in different currencies, and credit default swaps (CDS), which transfer credit risk. Swaps are used extensively by banks, corporations, and institutional investors to manage interest rate, currency, and credit exposure.
Example
A corporation with $100 million of floating-rate debt enters a five-year interest rate swap with a bank, paying 4% fixed and receiving SOFR + 0.50%. The company converts its unpredictable floating payments into a fixed cost, making cash flow planning easier. The bank takes the opposite view, converting fixed income into floating income that may rise if rates increase.
Source: ISDA — Swaps Overview