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A swap is a form of derivative in which two parties agree to exchange payments. Almost anything can constitute a financial instrument, but swaps most commonly involve cash flows based on an agreed upon or notional amount. The notional amount specifies the principal dollar amount which determines the amounts of actual payments required under the swap. This will become clearer in an upcoming swaps example.
In a cash flow based swap each side sends cash to the other. One side is generally set at a fixed rate. The other side is the floating or variable payment based upon a benchmark interest rate, currency exchange rate or index price.
The most common type of swap in an Interest Rate Swap. In this type of swap the parties exchange cash flows based on a notional amount to hedge risk of an interest rate change, or to speculate.
Here’s an example of how it works
Party A has taken out a loan with its bank of $1,000,000 with a variable rate of 2.5 which can change at any time. To mitigate the risk of interest rates rising Party A enters into an interest rate swap with Party B.
Under the swap Party A agrees to pay Party B 3 percent of the notional amount of $1,000,000 (the fixed leg). Party B agrees to pay Party A the variable rate of the notional amount of $1,000,000 (the floating or variable leg). So as interest rates rise, Party A’s amount of the cash flow they receive from Party B also increases. This hedges the risk of rising interest costs on Party A’s loan.
If the interest rate starts to rise here’s what the swap would look like. Let’s say the variable interest rate rises to 4 per cent. Party A now owes the original lender of the loan 4 per cent of $1,000,000 or $40,000. Under the swap, Party A continues to pay Party B a set rate of 3 per cent of the notional amount, which is $30,000. With the change in the variable interest rate Party B will now pay Party A 4 per cent of the notional amount, $40,000. Typically, the net cash amount of the swap exchanges hand. In this example, Party B pays Party A $10,000. By entering into the swap, Party A hedged its exposure to increases in interest rates (i.e., $10,000) which in turn covers the interest rate increases on the original loan.