Forwards and Swaps: An Introduction
The private, over-the-counter side of derivatives: how a forward contract fixes a future price, how an interest rate swap turns floating-rate debt into fixed, what "notional" means in a market measured in hundreds of trillions, and why counterparty risk led to central clearing.
The short version
A forward is a futures contract made privately: two parties agree a price for a future date on whatever terms suit them, with no exchange and no daily settlement, so each depends on the other to pay. A swap is a series of such exchanges. In the most common kind, one side pays a fixed interest rate and the other a floating rate on the same notional amount, which lets a borrower fix the cost of a floating-rate loan. The over-the-counter market's notional value runs to hundreds of trillions of dollars, but notional isn't money at risk. The real risk is that the other side fails, which is why standardized swaps in the US now go through clearing houses.
By the end of this lesson, you'll be able to
- Describe how a forward contract fixes a future price and how it differs from a futures contract
- Work through the payments in a fixed-for-floating interest rate swap and show how it fixes a borrower's cost
- Distinguish notional amounts from market value, and explain counterparty risk and central clearing
Why this matters
Options and futures trade on exchanges, with published prices and a clearing house behind every trade. Much of the derivatives world doesn't. Banks, companies, and funds also agree derivatives directly with one another, over the counter, on terms written for the occasion. Few individual investors ever sign one, but the companies they own may use them to manage currency and interest rate risk, banks deal in them, and their regulation was overhauled after the 2008 crisis. This lesson introduces the two basic forms: the forward and the swap.
The forward contract
A forward is the simplest derivative: an agreement between two parties to buy or sell something at a price fixed today, on a date in the future. It's what a futures contract is before an exchange standardizes it. The two parties choose the quantity, the date, and the terms. Nothing is settled daily. Each side simply owes the other what was agreed when the date arrives.
A US company must pay a European supplier €1,000,000 in six months. Today a euro costs $1.10. Its bank offers a six-month forward at $1.1054 a euro, so the company locks in a cost of $1,105,400.
| Euro in six months | Cost without the forward | Cost with the forward | Forward's effect |
|---|---|---|---|
| $1.00 | $1,000,000 | $1,105,400 | Cost $105,400 more |
| $1.1054 | $1,105,400 | $1,105,400 | No difference |
| $1.20 | $1,200,000 | $1,105,400 | Saved $94,600 |
The forward rate is a little above today's because, in this example, dollar interest rates are higher than euro rates: 5% against 4% a year. The bank prices the forward so that neither borrowing dollars nor holding euros would beat it, the same carry logic as in Commodity and Index Futures.
The company isn't trying to make money on the euro. It's trying to know its costs. The forward gives up the chance of a cheaper euro to remove the chance of a dearer one. Exchange Rates and Your Returns coming soon covers the currency risk itself.
What the forward lacks
Because there's no exchange and no clearing house, two things that futures provide are missing.
- It can't simply be cancelled. Forward contracts can't be offset. Someone who buys a forward and then sells an identical one to a different party has obligations under two contracts, one long and one short.1 Both counterparties still have to perform.
- Each side depends on the other. If the euro rises to $1.20, the bank owes the company $94,600 of value. If the bank failed before the date, the company would be back to buying euros at $1.20. This is Counterparty risk. The risk that the other party to a contract fails to do what it promised, such as making a payment it owes. Glossary, and it's what an exchange's clearing house removes.
The rest of this lesson is for members
Still to come in this lesson: The swap, Notional and real exposure, From private deals to clearing houses, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Hedging with DerivativesDerivatives (depth track)
- The Major Risks of DerivativesDerivatives (depth track)
- What Futures AreDerivatives (depth track)
- Exchange Rates and Your Returns coming soonInternational Investing and Currencies (depth track)
Notes and sources
- Commodity Futures Trading Commission. Economic Purpose of Futures Markets and How They Work. Checked 2026-10-13. Back to text
- Bank for International Settlements. OTC derivatives statistics at end-June 2025 (December 8, 2025). Checked 2026-10-13.
- Federal Reserve Bank of New York. Secured Overnight Financing Rate Data. Checked 2026-10-13.
- Commodity Futures Trading Commission. Dodd-Frank Act. Checked 2026-10-13.