What are Swaps Derivatives?

Key Highlights

• Swaps derivatives are contracts that can be configured between two parties for the swap of liabilities or cash flows.
• The swaps are based on underlying commodities, equities, interest rates, currencies, etc.
• They've been traded in the OTC market mostly between banks and businesses.
• It's risky since one party can default on payment and thus give rise to a risk of default.

Understanding Swaps Derivatives Meaning

Swaps in derivatives are contracts or agreements between two parties which allow them to exchange liabilities and cash flows from several different financial instruments. Cash flow based on the notional principal of bonds and loans is most commonly involved in swaps. Any legally or financially valued instrument may be the underlying instrument used in swaps.

In swap contracts, the principal amount usually is not transferred. In addition, both cash flows remain fixed, and the other remains variable. The currency exchange rate, the benchmark interest rate or index rates shall be used as a basis for irregular cash flows. In addition, every exchange of funds is referred to as the Legged Transaction. Uncertain or random variables such as the foreign exchange rate, equity price, interest rate or commodity price will determine at least one of the cash flows at the start of the contract.

How does Swap Work?

Each swap contract is unique and customised. A standardised format is not available. The parties reach an agreement based on negotiations and conditions agreed upon. In addition, the contract is based on the notional principal amount and the cash flows generated are exchanged between the parties. Exchanges of cash flows will occur at a particular period according to the frequencies mentioned, i.e. between the starting and ending dates of the contract.

A financial regulator does not regulate these contracts because they are traded in the open market. As a result, they are a risky instrument because of the increased risk of counterparty default. Furthermore, there are various swap agreements in operation, and each type of contract has a specific purpose.

In most cases, businesses apply swaps to protect their risks and reduce the uncertainty of operations. Large companies, on the other hand, can finance their activities using bonds that yield interest to investors. However, if the company does not like interest payments, it may choose another firm for a swap.

Types of Swaps

The most common types of swaps used in the Indian capital markets are as follows.

1. Interest Rate Swap In interest rate swaps, commonly called plain vanilla swap contracts, counterparties trade cash flows to speculate or hedge interest rate risk. In general, such agreements are concerned with the exchange of a fixed rate for a floating rate. The cash flows will be based on the nominal underlying amount to which both sides agree but are not exchanged.

2. Currency Swaps The swap is for exchanging interest rates and principal payments on debt amounting to various currencies. Furthermore, it is exchanged together with specific interest obligations rather than being based on a notional principal amount. In addition, these agreements may take place in different countries.

3. Commodity Swaps The exchange of cash flows, dependent upon the price of commodities, is involved in commodity swaps. This contract includes two components: floating legs and fixed legs. The cost of the underlying item, such as oil, fuel, precious metal and so on, will be subject to a floating portion. The contract will state the firm leg according to the commodity producer.

4. Debt Equity Swaps Debt Equity Swaps involve the exchange of debt and equity or vice versa. This is a financial restructuring procedure where one party shares its debt with the other in exchange for an equity position. That is to say, a debt holder obtains an equity position to cancel the debt. Creditors forced to enter into such agreements due to bankruptcy can decide whether or not they wish to participate. In contrast, other creditors may choose to do so if they can benefit from favourable market conditions.

5. Total Return Swaps Total Return Swap is a mechanism for exchanging full returns from an asset at its assigned interest rate. This results in a fixed rate for an underlying asset such as stocks, bonds and indexes being charged to the party. Consequently, the benefit of this asset is passed on to the other party without the actual ownership of the asset. The parties to this swap contract are a total return payer and a total return receiver.

Benefits and Risks of Swaps Derivatives

The benefits of swaps in derivatives are as follows.

1. Hedging Risk Hedging of risks is the main advantage of swaps. It may help a party to reduce the risk associated with market fluctuations. For example, interest rate swaps are used to hedge the risk of changes in interest rates, while foreign exchange swap is used for hedging against currency fluctuations.

2. Access to New Markets Under these arrangements, investors or firms can enter unavailable new markets.

The most significant risk of derivatives swaps is the following.

1. Interest rate risk The movements in interest rates do not necessarily correspond to the expectations of these swap contracts. As a result, they are vulnerable to interest rate risk. In other words, only if the interest rate falls will the receiver profit, while the payer will profit only if the interest rate increases.

2. Credit risk Swaps are exposed to the credit risks of counterparties. This is because the other party to the contract tends to default on the payment. However, it is only possible to mitigate this risk to a certain extent.

Conclusion

Swaps in financial markets involve a derivative contract where one side exchanges the value of an asset or cash flow for another. For example, a variable interest-paying company could swap its interest payment with another firm that would pay an identical rate to the first one. Swaps can exchange other types of risks or values, e.g., potential credit default in a bond.