A swap is a privately negotiated agreement between two parties to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor). Entering a swap typically does not require the payment of a fee.
While swaps are used for various purposes—from hedging to speculation—their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability. For example, an investor realizing returns from an equity investment can swap those returns into less risky fixed income cash flows—without having to liquidate the equities. A corporation with floating rate debt can swap that debt into a fixed rate obligation—without having to retire and reissue debt.
Swaps are cash-settled over-the-counter derivatives. Except for forwards, swaps are the most simple form of OTC derivative.
SEC Proposes Term Rules
In April of 2011, the Securities and Exchange Commission (SEC) voted unanimously to propose rules further defining the terms “swap,” “security-based swap,” and “security-based swap agreement.” The rules were proposed jointly with the Commodity Futures Trading Commission (CFTC) and stemmed from the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The joint proposal of the SEC and the CFTC would add rules under the Securities Exchange Act of 1934 and provide interpretive guidance regarding which products would – and would not – be considered a “swap” or a “security-based swap” (referred to collectively in the proposing release as “Title VII instruments”).
Common types of swaps agreements include:
According to a survey by the International Swaps and Derivatives Association, Inc., (ISDA) the notional (underlying) outstanding value of credit derivatives - which for the purposes of the survey involved credit default swaps referencing single names, indexes, baskets and portfolios - grew by 32 percent in the first six months of 2007 to $45.46 trillion from $34.42 trillion. The annual growth rate for credit derivatives was up 75 percent from $26 trillion at mid-year 2006.