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What Are Swap Derivatives And Its Types

28 Apr 2023

An Overview

There are numerous prospects in the derivatives market. Regardless of your investment strategy or capital, you can make significant gains in the derivatives market. In contrast to equities cash, however, derivatives trading is very technical, and sufficient understanding is required to make big profits.

What Are Swap Derivatives?

Swap derivatives entered the Indian market in the late 1980s and soon gained popularity due to their ease of use and high profits. Indeed, swaps derivatives are among the most frequently traded financial transactions in the Indian capital market. 

Swap contracts, unlike options and futures, are executed between two parties over-the-counter. It allows two parties to enter into a financial agreement in order to exchange cash flows or liabilities. Through swap contracts, one party commits to pay some money in exchange for receiving money from the other side. The fundamental concept of swaps derivatives is notional amounts, like in loans or bonds. The swap end and start dates, payment frequency, the nominal amount, interest or margin rate, and the Index of Reference are typically included in a swap contract. 

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What Is The Distinction Between Options, Futures And Swaps Derivatives?

An options/futures contract allows you to sell or buy an underlying asset on a future date at a predetermined price. Futures contracts are classified as derivatives since their value is derived from an underlying asset. Options and futures are standardised contracts that are traded on stock or commodities markets like the Multi Commodities Exchange (MCX), National Stock Exchange (NSE) and others. 

Swap derivatives, unlike options and futures, are not traded on stock exchanges. They are, instead, over-the-counter instruments. Two parties agree to trade securities in order to enter into a swap contract. The transaction is not supervised or overseen by stock exchanges such as the MCX, NSE and others. Swap contracts are traded via decentralized dealer networks that have no physical location. In most cases, the counterparties in swap derivatives are huge corporations and financial institutions rather than individuals. This is due to the fact that the risk of counterparty default is always significant in swaps derivatives. 

Types Of Swaps In Derivatives

  • Commodity Swaps

It is made up of two parts: a fixed leg and a floating leg. The fixed leg refers to the floating rate supplied by the commodity's producer whereas the floating leg is related to the market price of an underlying commodity. Crude oil is the world's most widely traded commodity swap.

  • Interest Rate Swaps

The counterparties in interest rate swap contracts exchange their cash flows to hedge against interest rate risks. They can also profit from this by speculating. The cash flows are determined by a fictitious principal amount agreed upon by both parties. However, the sum is not first swapped. In the Indian capital markets, interest rate swaps are the most often traded swaps. 

  • Currency Swap

The counterparties exchange the interest and principal on the debt through a currency swap contract. Typically, currency swaps are denominated in distinct currencies. Currency swaps are a traditional hedging mechanism that investors employ to safeguard their capital from currency exchange rate changes.

Advantages And Drawbacks Of Swaps Derivatives

The following are the advantages of swaps derivatives: 

  • Access To New Markets: These contracts enable investors or businesses to enter previously untapped markets. A US corporation, for example, can enter into a currency swap with a British company to gain access to a more favourable dollar-to-pound exchange rate. This is because UK enterprises can borrow at a lower interest rate on the domestic market. 
  • Hedging Risk: The primary advantage of swaps is risk hedging. In other words, it can assist a party in reducing the risk associated with market swings. Interest rate swaps, for example, are used to hedge against interest rate variations, whereas currency swaps are used to hedge against currency exchange rate fluctuations. 

The following are the key risks associated with swaps derivatives: 

  • Credit Risk: Swaps are vulnerable to the counterparty's credit risk. This occurs when the other party to the contract fails to make payments on time. However, this risk can only be minimised to a certain amount. 
  • Interest Rate Risk: Interest rate changes may not always correspond to the presumptions of these swap agreements. As a result, they are vulnerable to the risk associated with interest rates. In other words, the recipient will benefit only if interest rates fall, but the payer will benefit only if interest rates rise. 
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