What is Swaps Derivatives? Understand Here!

6 mins read

What is a Swap?

When it comes to the exchange of cash flows, there are many traditional methods that are available in the market. These exchanges required the finances of the sender as well as the to be of the same financial instrument, To combat this challenge, swaps derivatives were introduced. It is a recent trend in this space. A swap is essentially a derivative contract with the help of which two parties can exchange either liabilities or cash flows from two completely different financial instruments. Most swaps derivatives don’t necessarily involve cash flows that are based on a principal amount that could be a bond or a loan. The instrument can be almost anything. Usually, there is no transfer of the principal amount involved.

One cash flow is usually fixed and the other cash flow is maintained to be variable. This variable aspect is based on the benchmark interest rate, index price, or the floating currency exchange rate. Each of these cash flows comprises one leg of the swap.

The most common type of swaps derivatives is the interest rate swap. Usually, swaps are not traded on exchanges. As a result, retail investors don’t usually engage in swaps. Instead, swaps are usually exchanged between businesses or financial institutions as they are considered to be over-the-counter contracts. Usually, these swaps are customized to the needs of both parties.

Different Types of Swaps

There are 6 different types of swaps that are available in the market. Let us have a look at each of them.

  1. Interest Rate Swaps

Now that we have understood that interest rate swaps are the most common type of swaps, let us dive deeper into this type and understand it thoroughly. With respect to an interest rate swap, the main aspect is that the parties involved in this swaps derivatives exchange cash flows on a principal amount. This is done to hedge against the risk associated with the interest rate or to even speculate. For instance, assume that a certain business had issued a certain amount of money in three-year bonds with an annual interest that is variable. This varying interest rate causes a certain level of anxiety for the business especially with regards to a rise in the rate of interest.

In response, the management team of this company finds another company that is willing to pay a fixed interest rate, although it may not be as high or rewarding. In simple terms, the new company will pay the interest rate for the three-year bond offered by the other company. In this case, the company issuing the bonds will benefit greatly from the swap if the rates rise significantly over the next three years.

  1. Debt-Equity Swaps

With a debt-equity swap, the primary function is that it involves the exchange of equity or debt. This happens in the case of a publicly traded6 company. This way, bonds would be purchased synonymous with stocks. This is a means for companies to re-allocate their capital structure and also to refinance their debt.

  1. Credit Default Swaps

The main aspect of a credit default swap is that it consists of an agreement by one party to pay for the principal that is lost and the interest of a loan to the buyer of the credit default swap in case a borrower defaults on a loan. A combination of poor risk management along with excessive leverage in the credit default swap market was a combining cause for the financial crisis that occurred in 2008.

  1. Currency Swaps

In a currency swap, both the interest as well as the principal payments are exchanged on the debt that is denominated in different currencies. This is different from an interest rate swap as a principal swap is not a notional amount, Rather, it is exchanged along with certain interest obligations. Currency swaps also have the option to take place between countries.

  1. Commodity Swaps

This type of swap involves the exchange of a floating commodity price for a certain set price over a period of time that is previously agreed upon. Usually, commodity swaps largely involve crude oil.

  1. Total Return Swaps

When it comes to a total return swap, the total return from an asset is usually exchanged at a pre-determined and fixed interest rate. This way, the party pays a certain fixed-rate exposure to an underlying asset that is most commonly an index or a stock. For instance, a particular investor can pay a fixed rate to any one party in return for capital appreciation along with the dividend payments of a series of stocks.

What is the Swap Curve?

The swap curve is a plot that represents the rates across all the available maturities. As the swap rates typically incorporate a large overview of the forward expectations for LIBOR and the perception of the market on other factors such as credit quality of banks, liquidity, supply and demand dynamics, etc., the swap curve is crucial when it comes to understanding the interest rate benchmark. While the swap curve can be similar in shape to the sovereign yield curve, swaps can usually trade either lower or even higher than sovereign yields. The primary difference between the two is the swap spread.

What are the Risks Involved With Swaps Derivatives?

Similar to most of the fixed-income investments associated with non-governmental bodies or associations, interest rate swaps have their risks too. There are two common risks associated with interest rate swaps namely credit risk and interest rate risk. As the interest rate movements don’t necessarily match the expectations these swaps are prone to risks associated with interest rates. In simple terms, the receiver will profit if there is a fall in the interest rate. In contrast, the payer will profit if there is a rise or increase in the interest rate.

Swaps are also prone to the credit risk of the counterparty. This happens given the chance that the other party in the contract tends to default on their responsibility. Since the financial crisis, this risk has been mitigated to an extent.

In a Nutshell

There are several different types of swaps derivatives that can help with cash flow and allow them to not be associated with a certain principal amount. Usually, the principal amount is not exchanged. Such types of exchanges are commonly carried out with businesses, institutions, and financial entities.