Swaps & Other OTC Derivatives

A swap is a derivative contract in which two counterparties agree to EXCHANGE streams of cash flows over a set period. Each stream (called a 'leg') is calculated by applying an agreed rate or price to a reference amount, and the two legs are netted and settled on scheduled dates.

Like all derivatives, a swap's value is DERIVED from an underlying — an interest rate, a currency's exchange rate, a credit event, a commodity price or an equity return. No principal changes hands purely as a loan; instead the parties simply swap the cash flows that the underlying generates.

Swaps are typically traded OVER-THE-COUNTER (OTC): they are privately negotiated between two parties (often via a dealer/bank) rather than bought and sold on an exchange, so terms such as maturity, payment frequency and notional can be tailored ('bespoke').

The standard documentation framework for OTC derivatives, including swaps, is the ISDA Master Agreement, which governs netting, default and collateral terms between the counterparties.

The NOTIONAL PRINCIPAL (or notional amount) is the reference figure used to CALCULATE the cash flows on each leg. It is generally NOT exchanged between the parties — it exists only to size the payments.

For example, in an interest-rate swap the two interest legs are each computed on the notional, then netted; the notional itself never moves. This is why a swap's economic exposure can be very large relative to the cash actually settled.

The main exception is the currency swap, where the principal amounts ARE typically exchanged (in different currencies) at the start and re-exchanged at maturity, because the two legs are in different currencies.

Because payments are a fraction of a large notional, swaps embed LEVERAGE: a small movement in the underlying rate or price produces a comparatively large change in the contract's value.