What are Swap Derivatives?

Swap derivatives are contracts in which two parties agree to exchange liabilities or cash flows from different financial instruments. Swap trading is based on loans or bonds, referred to as a notional principal amount. As long as the underlying instrument has a legal, financial value, swaps can use any type of underlying instrument. As a rule, the principal amount remains with the original owner in a swap contract. One cash flow may be fixed, but the other may be variable, based on a floating currency exchange rate, benchmark interest rate, or index rate. This article provides an overview of what are swap derivatives by explaining its types, working, benefits and more. 

How Does a Swap Derivative Work? 

To get a better understanding of what is swap, investors need to learn how it works: 

• Swap contracts do not follow a standardised format.  
• Every contract is unique and tailored to meet the client's needs.  
• After the parties have negotiated, a contract is executed based on the conditions that have been agreed upon by both parties. 
• Swap contracts are based on a notional principal amount. The parties exchange the cash flows earned on it.  
• The swap contract also specifies a start and end date. During this period, cash flows are exchanged at specified intervals. 
• Due to the fact that these are traded over the counter, there is no mechanism to oversee them. As a result, counterparty defaults are more likely to occur, making these contracts risky to enter into. 
• Swap deals operate differently depending on their type. Furthermore, each type of swap serves a specific purpose. 

Having understood swap derivatives meaning, and how they work, this article further discusses their types to help investors make informed decisions. 

Types of Swaps in Derivatives 

Interest rate, commodity, credit-default, debt-equity, total return, and currency are the main types of swaps. The detailed explanation of each swap is given below: 

Interest Rate Swaps  

It is the most common type of swap contract, in which a fixed exchange rate is swapped for a floating exchange rate. For example, X and Y may enter into an interest rate swap. Here, X agrees to pay Y a fixed interest rate. In return, Y pays X interest at a floating rate. Throughout the duration of the contract, interest payments are made at specified intervals. In this way, the parties are able to minimise the risk of interest rate fluctuations. It is also known as a plain vanilla swap. 

Commodity Swaps  

The majority of producers engage in a swap with buyers and fix a price for selling the commodity. As a result, they are able to minimise the losses that may result from price fluctuations. Commodities such as grains, crude oil, and metals may be the underlying asset in such a swap. A spot price determines the value of such commodities, which can be volatile. 

Credit-default Swaps  

The purpose of this type of swap is to protect a lender against the risk of default by a borrower. The lender receives a guarantee from a third party that the principal and interest will be paid if the borrower is unable to repay. As a result, lenders are able to take on less risk and borrowers are able to obtain loans more easily. It is important to note, however, that the swap contract is only implemented if the borrower defaults. 

Debt-equity Swaps  

In this swap, debt is exchanged for equity or vice versa. It is a method of restructuring a company's capital. It is common for companies to do so when they are unable to meet their debt obligations. The shift to equity allows them to push back the repayment date. 

Total return Swaps  

In a total return swap, one party provides interest at a fixed rate to the other party. Suppose, for example, A owns shares that are subject to price fluctuations and provide other benefits such as dividends. He enters into a swap agreement with B. B agrees to provide A with a fixed interest rate. As a result, A's risk is reduced because he receives a stable return. In exchange, B benefits from the price changes, dividends, and appreciation of the value of its shares. 

Currency Swaps  

Currency swaps involve the exchange of interest on a loan amount. The amount is expressed in separate currencies. There are many businesses that use this method to avoid foreign exchange taxes and obtain easy loans in a local currency. It is also common for governments to enter into such contracts in order to stabilise fluctuations in exchange rates. 

Benefits and Risks of Swap Derivatives 

Swap derivatives have several advantages. However, they also have some risks associated with them. Let’s understand the benefits and drawbacks of swap derivatives.  

The advantages of swap derivatives include the following.  
 

Risk Management 

Swaps can be useful for risk management. They are utilised in hedging off multiple kinds of risks, including those about changes in interest rates or currency prices. In this light, interest rate swaps protect against fluctuating interest rates, while currency swaps protect against fluctuations in currency exchange rates.
 

Market Access

Swap contracts also help access new markets that might have been out of reach. The obvious choice would be the Indian company, which would be able to cut down its local borrowing costs by swapping US dollars with a US Company at a favourable USD to INR exchange rate.  
 

The risks of swap derivatives are as follows.

Interest Rate Risk 

Interest rate swaps are sensitive to unexpected changes in interest rates. The recipient would benefit if interest rates fall, while on the opposite, payers benefit if interest rates increase.

Credit Risk

At the same time, swaps are out under the risk of the counterparty's credit-which means some kind of default on the obligations by another party. Although that risk was somewhat mitigated following the financial crisis, it perhaps remains one of the key issues for individuals trading swaps. 

Disclaimer: All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

A swap is a financial derivative transaction wherein two parties exchange cash flows or asset values. For instance, a business that charges variable interest rates might exchange those payments for fixed rates with another company, which would then pay the first business. Swaps can also trade other kinds of risk or value, such as the possibility of a bond's credit default. Hence, they can be quite useful for traders. They should learn what is swap and try to benefit from its unique features. A good online trading app will enable traders to make well-informed derivatives trading decisions.