What is a Back-to-Back Swap?

A back-to-back swap is a type of financial agreement. It is made by a bank or company. The goal is to get rid of certain risks that come with an existing swap agreement the bank already has.

What is a Swap?

First, let’s talk about what a regular “swap” is. A swap is a deal between two groups. They agree to exchange (swap) one kind of payment for a different kind of payment.

Usually, the payments are based on things like interest rates or foreign currencies. For example:

• One side might pay a fixed interest rate. The other side pays a changeable rate.
• Or, one side pays in U.S. dollars. The other side pays in Euros.

The groups decide ahead of time how much and how often they will pay. The swap can last for a few months or many years.

Risks of a Swap

Swaps can help banks and companies in many ways. But they also come with risks.

Market Risk

One risk is that the value of the swap might change in a bad way. This could happen if interest rates or currency values change a lot. The bank could end up losing money. This is called “market risk.”

Counterparty Credit Risk

Another risk is that the other group in the swap might not be able to pay. Maybe they have money problems. Then the bank doesn’t get the payments it expected. This is called “counterparty credit risk.”

What a Back-to-Back Swap Does

So, banks look for ways to deal with these risks. One way is to do a back-to-back swap.

In a back-to-back swap, the bank finds another group to do a second swap with. This new swap is the opposite of the first swap.

Example

Let’s say the bank has a swap where:

• It pays a fixed rate
• It gets a changeable rate

For the back-to-back swap, the bank would:

• Pay the changeable rate
• Get a fixed rate

The changeable and fixed rates in the back-to-back swap match the ones from the first swap.

Effect on Risks

The back-to-back swap helps with some risks, but not all.

Market Risk

The back-to-back swap gets rid of market risk. The payments from the two swaps balance each other out.

If the changeable rate goes up:

• The bank has to pay more on the back-to-back swap
• But it also gets more on the first swap

The opposite happens if the rate goes down. So the bank is protected from changes in the market.

Counterparty Credit Risk

But the back-to-back swap does not get rid of counterparty credit risk. In fact, it adds more risk.

Now the bank has to worry about two other groups paying – not just one. If either group has money problems and can’t pay, the bank loses out.

Why Use a Back-to-Back Swap?

You might wonder why a bank would use a back-to-back swap. Why not just end the first swap?

In many cases, the bank can’t easily get out of the first swap. The agreement might not allow it. Or there might be big fees to end it early.

The back-to-back swap solves this problem. The bank can keep the first swap but still protect itself from some risks.