A swap is an OTC derivative agreement in which two parties exchange cash flows at specified intervals over a defined period based on an underlying notional principal amount (which is generally not exchanged). The most common type is an interest rate swap: one party pays a fixed rate while the other pays a floating rate (typically SOFR or a similar benchmark). This allows a company with fixed-rate debt to synthetically convert it to floating-rate exposure (or vice versa).
In a plain vanilla interest rate swap, the fixed-rate payer benefits when rates rise (paying below-market fixed while receiving rising floating); the floating-rate payer benefits when rates fall. Currency swaps involve exchanging both principal and interest payments in different currencies. Credit default swaps (CDS) function like insurance: the protection buyer pays periodic premiums; the protection seller pays a lump sum if a specified credit event (default) occurs.
Swaps are not traded on exchanges (though some standardized swaps are now centrally cleared through clearinghouses per Dodd-Frank requirements). They are not securities under the Securities Act of 1933 for most purposes; they are regulated under the Commodity Exchange Act by the CFTC (security-based swaps are jointly regulated by the CFTC and SEC).
The notional principal is used only to calculate payment amounts — it is never actually exchanged in a standard interest rate swap. Swap risk includes interest rate risk, counterparty risk, and basis risk.
> Exam tip: On the Series 65/66 and CFP, understand how an interest rate swap can convert floating-rate debt to fixed-rate (or vice versa) without refinancing. Know that the notional principal is NOT exchanged in an interest rate swap. CDS are particularly important in post-2008 exam content — understand that they can be used for hedging or speculation.