Swaps: interest rate, credit default and total return
A swap is an agreement between two parties to exchange cash flows over time. Swaps are traded mostly between institutions, but they underpin mortgages, corporate borrowing and bank risk management.
The main types
| Swap | What is exchanged | Used for |
|---|---|---|
| Interest rate swap | Fixed rate for floating (e.g. SONIA, SOFR) | Fixing borrowing costs, betting on rates |
| Cross-currency swap | Payments in one currency for another | Funding abroad, hedging FX |
| Credit default swap | Regular premium for a payout on default | Insuring or betting against credit |
| Total return swap | All returns on an asset for a financing rate | Exposure without owning the asset |
Interest rate swaps
A company with a floating-rate loan worries that rates will rise. It enters a swap: it pays a fixed rate and receives floating. Its floating loan payments are now offset, leaving it effectively paying fixed. Banks, pension funds and insurers use swaps to match the interest rate risk of assets and liabilities. The rate at which fixed is swapped for floating (the swap rate) is a key benchmark in its own right, and directly affects UK fixed mortgage pricing.
Credit default swaps
A CDS works like insurance on a bond. The buyer pays a regular premium. If the borrower defaults, the seller pays out. CDS spreads are a live market price of default risk. Crucially, you don't have to own the bond to buy protection, so CDS can be used to bet on default.
In 2008, AIG had sold protection on vast amounts of mortgage-related debt without holding enough capital against it. When those securities collapsed, AIG couldn't pay and needed a government rescue of around $180 billion.
Total return swaps
A TRS gives you the full return of an asset (price moves plus dividends) without owning it, in exchange for paying a financing rate. The bank on the other side holds the shares as its hedge.
In 2021, Archegos Capital used total return swaps with several banks to build enormous, concentrated, highly leveraged positions. Because they were swaps, no one bank, and not the market, could see the full size. When the stocks fell, Archegos couldn't meet margin calls and the banks dumped shares. The banks lost over $10 billion combined, with Credit Suisse alone losing around $5.5 billion.
Key takeaway
Swaps let institutions reshape risk precisely. The danger is the same as with all derivatives: leverage and hidden exposure that only becomes visible when it is too late.
Educational content only, not financial advice. Options involve significant risk and are not suitable for everyone.