Home / Course / Module 3 / Swaps and Other Derivatives
Module 3 · Lesson 4 of 6A swap is an agreement to exchange streams of payments over time. Swaps are the largest part of the OTC derivatives world, and understanding them also clears up why the word 'swap' appears on a retail trading statement.
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A swap is a contract in which two parties agree to exchange payments on set dates for a set period. Each payment is calculated from a formula that depends on something such as an interest rate, an exchange rate or a commodity price.
Think of two neighbours. One has a mortgage whose payments rise and fall with the central bank rate and wants certainty. The other has a fixed-rate mortgage and expects rates to fall. If they could agree to cover each other's payments, each would get the type of payment they prefer. Swaps do this in a formal way between companies, banks and governments.
Three terms matter.
Swaps are OTC contracts, so they are tailored and carry counterparty risk, as described in What Are Derivatives?. In practice they are used mostly by institutions, not individual traders.
A swap does not usually move the large notional amount. Only the difference between the two payment streams changes hands, which is why a large swap can be settled with a small payment.
The interest rate swap is the most common type. It lets a borrower turn a floating-rate loan into a fixed-rate one, or the reverse.
A company has a £10,000,000 loan that charges the floating benchmark rate. It worries rates will rise. It enters a swap in which it pays 4% fixed and receives the floating rate on a notional of £10,000,000. Settle once a year.
Year 1: floating rate resets at 4.5%.
Year 2: floating rate resets at 3.2%.
The company's cost is fixed at 4% in both years. In year 2 it would have been cheaper not to hedge, but the aim was certainty, not guessing the rate.
The counterparty, often a bank, has the opposite position. It gained in year 2 and lost in year 1. One person's certainty is another's open risk, and the bank prices that into the fixed rate it offers.
In a currency swap, two parties exchange principal and interest in different currencies. A UK firm needing dollars and a US-based firm needing pounds can swap borrowings. Unlike most interest rate swaps, the principal is often actually exchanged at the start and handed back at the end at the same agreed exchange rate. A related short-term product, the FX swap, pairs a spot currency trade with an opposite forward trade and is widely used by banks to manage funding.
Example (hypothetical): at the start, £8,000,000 is swapped for $10,000,000 at an agreed rate of 1.25 (8,000,000 x 1.25 = 10,000,000). At the end the same amounts are swapped back, whatever the market rate is by then. Interest is paid in between in each currency.
A credit default swap works like insurance against a borrower failing to repay. The protection buyer pays a regular premium. If the borrower defaults, the seller pays compensation.
An investor holds £5,000,000 of bonds issued by a company. They buy protection at an annual premium of 2% of the notional.
If no default happens, the investor has paid £100,000 a year for protection they never used, like unused insurance.
A commodity swap exchanges a fixed price for a floating commodity price on a set quantity. An airline might pay a fixed price for fuel and receive a floating market price so that its fuel cost is predictable. The same structure can be built for gold or silver.
| Product | What it is | Key point |
|---|---|---|
| Warrant | A long-dated option-like instrument, often issued by a company or bank | Can lose all value; issuer risk applies |
| Spread bet | A UK product where you bet an amount per point of price movement | Behaves like a CFD in risk; tax treatment differs, check with a qualified professional |
| Structured product | A bundled product that combines a bond with a derivative | Often complex; read the terms and fees carefully |
| Exchange-traded note or fund with gold exposure | A listed product that tracks a price | Some are backed by real metal, some use derivatives; check how it is built |
Complex products sometimes look simple on the front page. A good habit is to ask three questions before going near anything unfamiliar: what exactly do I own or owe, who is on the other side, and what is the worst thing that could happen?
If you cannot explain a product to a friend in a few sentences, you are not ready to trade it. Complexity is where hidden costs and unexpected losses live.
Here is a point that confuses many new traders. On a retail trading platform, swap usually means the overnight financing charge or credit applied if you keep a position open past the daily cut-off time. It is a cost or small payment linked to interest rates, not a swap in the institutional sense described above.
The idea behind it is related, though. Holding a leveraged position overnight is like borrowing money to hold it, and the rate difference between the two sides of a currency pair, or the cost of funding the position, produces a daily charge or credit.
Suppose a broker charges an annual financing rate of 7% on a long position with a notional value of £20,000.
Rates and rules vary by broker and product, so always read the financing terms. For the forex version, see Swaps, Rollover and Carry, and for how it applies to gold CFDs see CFDs Explained.
Institutional swaps shape interest rates, currency markets and credit conditions that in turn move gold, so you benefit from knowing they exist. And on your own account, the daily financing charge is a real cost that can quietly eat into a position held for weeks.
Not in the way banks and companies do. These are mostly institutional OTC contracts. Retail traders usually deal in products such as CFDs.
No. Depending on the product, direction and rates, it can be a small credit. Brokers also add a markup, so it is more often a cost than a credit. Check your broker's terms.
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