What Are Swaps?

Definition & Examples of Swaps

Bull and bear figurines on list of share prices
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A swap is a contract between two investors derived from an underlying asset each party has that the other can benefit from. Assets do not change ownership—what is swapped is one or more of an investment's benefits.

Swaps are traded over-the-counter, which means that individual investors do not generally trade them. However, methods are emerging that allow interested investors and traders to add swaps to their portfolios.

Learn more about swaps, how they work, and how they can be invested in using exchange-traded funds.

What Are Swaps?

A swap is an agreement between two traders to exchange an investment asset's benefits at a predetermined date. They are an exchange of a series of payments between two traders. Swaps are not limited to one type of investment—a swap can be agreed on for stocks, bonds, exchange-traded funds, commodities, foreign currencies or even interest rates.

How Do Swaps Work?

Companies use swaps to hedge the risk of financial decisions such as issuing bonds or stocks. If one company feels that they need to issue bonds but aren't comfortable with the interest payments they'll need to make on them to the holders, they could look for another company to swap with.

For example, suppose Company X issues bonds with a variable interest rate but is concerned over rising rates. In that case, they might look for another company that would agree to pay that bond interest for them.

If Company Y agrees to pays the interest for them, they could ask for a fixed rate interest payment on a set amount of money. If interest rates go up, Company X benefits more because they might be paying less interest to Company Y; however, if rates go down, Company Y might benefit because they receive more from Company X.

Generally, one side of the contract agreement is set while the other is variable.

Swaps can have multiple financial exchanges during the life of the contract. The contract can be negotiated to last however long a business feels necessary. Sometimes, one side of the swap agreement may want to end the contract before its final expiration.

At that point, both traders can agree on the deliverable, or settle on a cash equivalent for the contract or even create a new contract position. Swap contracts do not trade on public exchanges and therefore are not regulated—meaning both parties are free to make agreements as they see fit.

What Do Swaps Mean to Individual Investors?

Typically swap contracts are executed by major financial institutions and established banks. As such, investors engaged in swaps need to have a large capital capacity and ability to make the payments negotiated.

ETFs are one of the newer types of investments available—they first appeared on the market in 1993. Swaps have been combined with ETFs to make them available to the general investing community.

Swap ETFs

In October 2020, the Securities and Exchange Commission voted to give investment companies the ability to include derivatives in their funds. This vote allowed companies such as mutual funds and ETFs to have swaps in their funds.

Swap-based ETFs must follow certain criteria such as having a risk management program, limits on leveraged risk and specific recordkeeping to safeguard investors.

Individual investors looking for ways to invest in swaps can find swap-based ETFs, also called synthetic ETFs. Derivatives and swaps are used in these ETFs to help keep the fund in line with the index the ETF tracks.

Synthetic ETFs don't own any of the underlying assets but are designed in two ways—funded and unfunded.

In funded synthetic ETFs, the ETF gives the pooled holdings to the counterparty. In exchange, the counterparty pays the returns. In an unfunded swap-based ETF, the ETF follows an index but might not hold any of the index's securities.

The unfunded ETF pays the counterparty the returns from the securities in the ETF, and the counterparty pays the returns of the securities from the index.

Swap Risks

There is a higher default risk due to the lack of regulation of swaps. Still, swaps are solid investments for those who can afford to get into them because high-value businesses initiate them.

Investors face additional risks besides market risk from the underlying investments. Counterparty risks include risks that the other swap party might default on its obligations.

Conflict of interest risk arises if parties involved in the swap take on multiple roles within the fund or swap. The conflict of interest comes from one party having too much invested in the swap.

If there is collateral offered, collateral risks take the shape of a decrease in value or have no bearing on the ETFs objective. If a swap ETF is concentrated in a specific market segment, investors face concentration risk.

Key Takeaways

  • Swaps are an agreement between two investors to exchange cash flows, payments or liabilities on an asset.
  • A swap can be derived from stocks, bonds, commodities, currencies or any other investment instrument.
  • Swaps are not traded on an exchange but are traded between private parties over-the-counter.
  • Swaps are generally not available to average investors unless they are part of an exchange-traded fund or another type of fund.