An agreement to exchange fixed interest payments for floating payments on a notional amount, the largest derivative market in the world by outstanding notional.
A payer swap pays fixed and receives floating; a receiver swap does the reverse. On a $50 million five-year swap at 4% fixed against a floating benchmark, if the floating rate averages 4.6% over a period the fixed payer receives the 0.6% difference on the notional for that period.
Corporates use them to convert floating debt to fixed or the reverse; pension funds use them to match long-dated liabilities under a liability-driven-investing mandate; banks use them to manage the rate mismatch between assets and funding.
The exposure is measured in dv01 rather than in notional. Swaps are now largely cleared, so daily variation-margin flows on mark-to-market moves, which turns an off-balance-sheet contract into a live cash requirement when rates move sharply.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
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