Swap Derivatives: Its Meaning and Definition

Swap derivatives are financial instruments that play a pivotal role in risk management and hedging strategies. In essence, a swap involves the exchange of cash flows or other financial instruments between two parties, providing a flexible tool for mitigating various types of risks in the financial markets. Understanding the meaning and definition of swap derivatives is essential for investors and businesses looking to optimise their financial positions and navigate the complexities of modern financial markets.

Defining Swap Derivatives

Swap derivatives came into the Indian market in the late 1980s, and they gained a fair amount of popularity due to their simple approach and returns. These are contracts that allow two parties to exchange liabilities or cash flows from two completely different financial assets.

• Most swap derivatives encompass diverse instruments beyond cash, including bonds and various agreements.
• Typically, there is no transfer of the principal amount in these trades, emphasising the exchange of cash flows or liabilities.
• Swap contracts often involve one fixed cash flow and another variable one, dependent on benchmarks like index prices, exchange rates, or currency rates.
• Over-the-counter (OTC) transactions facilitate the exchange of contracts between parties, allowing them to enter into financial agreements for cash flow or liabilities.
• Swap instruments include key features such as start and end dates, nominal amounts, frequency, margin, and interest rates.
• Interest rate swaps are among the most common types of swaps, and these financial instruments are usually tailored to the specific needs of the parties involved.
• Swaps are predominantly traded between businesses or financial institutions, with customised constructs reflecting the unique requirements of each party.

Process for a Swap Transaction

• In a swap contract, there are no standardised formats or regulations that follow the check of these contracts. Each contract is unique and customised by both parties.
• After negotiating, the parties enter into a contract based on the conditions to which they agree. A swap contract specifies the start and end date of the contract.
• The cash flow is exchanged along with the specified interest within the specified time frame.

Since there is no authority involved, the mechanism of these trades can be risky. This increases the chance of counterparty default, late payments, and other types of risks. There are different types of swap deals that work differently, each of them explained in the below paragraph.

Types of Swaps

There are different types of swaps that differ in operation as given in the explanation below.

Interest Rate Swaps

• It is one of the most popular types of swap contracts, wherein the fixed exchange rate is swapped for a floating exchange rate.
• So, for instance, A and B enter into the interest rate swap. A agrees to provide B with an interest rate at a predetermined fixed rate of interest.
• This interest payment is predetermined at specific intervals throughout the life of the contract.
• Both parties can hedge the risk that arises from interest rate fluctuations. You can also call this swap a plain vanilla swap.

Commodity Swaps

• In most cases, raw material traders or producers enter into a swap with the buyers and fix the selling price of a commodity. This helps them mitigate the losses that may arise from fluctuations in price.
• The underlying asset of such a swap can be a commodity such as fuel, grains, and metals.
• The lender assumes the value of such a risk, allowing borrowers to take advantage of low-interest loans.

Debt-Equity Swaps

• This swap involves the exchange of debt for equity or equity for debt.
• This method is used to restructure the capital of a company.
• Companies that are unable to pay their dues on the debt have undertaken these shifts to equity, which allows them to push their repayment time.

Credit-Default Swaps

• This type of swap is handy in cases where the lender is on the verge of default.
• It works as insurance for the lender.
• Third-party guarantees that the borrower will pay the principal amount as well as the interest, which will be forwarded to the third party.
• The lender can avoid the risk and get assurance of their contract with the other party.

Total Return Swaps

• Here, two parties involved in the trade provide interest to one party, which provides interest at a fixed rate to the other party.
• Consider an example where Jack owns shares that have price volatility and other benefits, such as dividends. He entered into a swap contract with Jin. Jin agrees to provide Jack with a fixed interest. Jack reduces the risk and gets a stable return. Jin will benefit from the price fluctuations, dividends, and other perks of owning shares.

Currency Swaps

• A large amount of loan and interest is exchanged between two parties in a currency swap.
• This amount is separate for different currencies.
• Businesses use this to avoid foreign exchange differences, charges and taxes and get easy loans in local currency. Government bodies also enter into such contracts to stabilise the currency exchange rate.

Understanding a Swap Curve

The swap curve delineates the correlation between swap rates across various maturities, akin to a yield curve for bonds. This curve signifies the anticipated returns of a swap upon maturity, resembling a bond’s yield curve, and is constructed as a par curve based on par swaps.

Benefits of Swap Derivatives

There are two major benefits of swap trading; these are as follows:

Avoiding Risk

One of the primary functions of swaps is to hedge risk. Consider an example where the interest rate swaps can hedge against fluctuation and the currency swaps are used to hedge against the price change of currencies.

Open a New Method of Trade

Companies can use this swap contract as a tool for accessing previously unavailable markets. For example, suppose an Indian company can opt to enter into a currency swap with a US company. In that case, you can access the more attractive USD-to-INR exchange rate because the Indian-based company can borrow domestically at a lower rate of exchange.

Conclusion

A swap contract is a customisable contract where two parties can agree on a certain time, rate of interest, and amount. Swaps are based on underlying contracts such as commodities, equities, bonds, etc. It is traded over the counter, where there are no regulatory or central platforms to perform this trade. A swap contract is a riskier trade in which one party defaults and the contract appears to go the other way.

Frequently Asked Questions (FAQs)