Swaps Obligate Each Party to the Contract to Exchange (Swap) a Set of Payments for Another Set of Payments

In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments (not assets) it owns for another set of payments that are owned by another party. Swaps are of two basic kinds. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency. We focus on interest-rate swaps.

Interest-rate swaps are an important tool for managing interest-rate risk. They first appeared in the United States in 1982, when, as we have seen, demand increased for financial instruments that could be used to reduce interest-rate risk. The most common type of interest-rate swap (called the plain vanilla swap) specifies: (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges will continue to be made. There are many other, more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap. Figure 13-4 illustrates an interest-rate swap between First Trust and the Friendly Finance Company. First Trust agrees to pay Friendly Finance a fixed rate of 7% on $1 million of notional principal for the next 10 years, and Friendly Finance agrees to pay First Trust the one-year Treasury bill rate plus 1% on $1 million of notional principal for the same period. Thus, as shown in Figure 13-4, every year First Trust would be paying the Friendly Finance Company 7% on $1 million while Friendly Finance would be paying First Trust the one-year T-bill rate plus 1% on $1 million.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 332.