What is Swaps Derivatives?

Swaps are one of the most powerful yet lesser-known instruments in the world of derivatives. Unlike futures, options or forwards that most people are familiar with, swaps are agreements between two parties to exchange financial obligations. They are widely used to manage risks such as interest rate fluctuations and currency movements, making them an essential part of today’s global financial markets.

In this blog we will explain what swap derivatives are, how they work and the different types you should know about. Whether you are a finance student, trader or investor, this guide will help you build a clear understanding of swaps.

What is Swap in Derivatives? 

Swaps derivatives are a type of financial contract in which two parties agree to exchange future cash flows. The exchanged cash flows are typically linked to financial variables such as interest rates, currencies, commodity prices, or credit risk, and the primary purpose of swaps is to hedge risk, manage exposure, or speculate on market movements. This exchange takes place on the basis of predefined rules and a notional amount, but the actual amount is not exchanged. Swaps often take place in the OTC (Over-the-Counter) market, that is, they are not listed on a bank or exchange, but are directly negotiated between two parties. This is why they are completely customized; the parties can set the terms as per their convenience. Not being standardized like futures and options, swaps in derivatives are more flexible, but they also have counterparty risk associated with them. The biggest advantage of swaps derivatives is that with their help companies can protect themselves from interest rate risk, currency fluctuation or commodity price volatility. Sometimes they are also used for arbitrage or speculative purposes.

History & Evolution of Swaps Derivatives

1. Early 1980s

Interest rate swaps were conceptualized in the late 1970s, and were used in the interbank market in the early 1980s. The British Bankers’ Association standardized them, making them increasingly popular in financial markets.

2. 1981: The First Currency Swap between IBM and World Bank

The first documented and high-profile deal involving swap derivatives occurred in 1981, when IBM and the World Bank signed the first currency swap agreement. The deal proved to be a major turning point in international financial strategy.

3. 1990s: The Rise of Credit Default Swaps (CDS)

Bankers Trust in 1991 and J.P. Morgan in 1994 used CDS as a form of credit risk management. It was a type of contract that provided financial protection in case of default.

4. 2008: Global Financial Crisis and the role of CDS

Excessive use of CDS without proper controls worsened the financial crisis of 2008. Large institutions like AIG came close to collapse due to CDS exposure, after which global regulators tightened regulation of the swap market.

5. 2025 Statistics

According to the ISDA report, the notional outstanding of global OTC derivatives was $699.5 trillion by the second half of 2024, of which interest rate derivatives alone accounted for $579 trillion. This segment makes up the largest part of the OTC derivatives market and has recorded a growth of around 4.9% year-on-year.

How Do Swaps Derivatives Work? 

• Nature of the contract : A swap derivative is a bilateral contract in which two parties agree to exchange future payments on pre-determined terms for a fixed period of time. These payments are based on an underlying financial factor, such as interest rates or currency rates.
• Calculation of payments : In this contract, payments are fixed based on a fixed notional amount. This amount is only for calculation, and there is no actual transaction. For example, one party pays at a fixed interest rate, while the other pays at a floating rate .
• Interval and settlement : Both parties calculate their respective payment amounts at a fixed interval (such as every 6 months). In the end, only the difference between the two payments is transacted. This is called net settlement. This prevents either party from making a full payment unnecessarily.
• Change in value : The value of a swap contract keeps changing over time. As the underlying rate (e.g. interest rate) fluctuates, the present value of the contract fluctuates. This is called the mark-to-market valuation.
• Purpose and utility : The purpose of this process is not just to exchange payments but to strategically manage risk. Corporates and financial institutions use it to manage interest rate risk or control costs without changing their existing loan or investment structure.

Types of Swaps in Derivatives

1. Interest Rate Swap

In this swap, two parties transact interest rates – one at a fixed rate and the other at a floating rate. Its purpose is to avoid the risk arising from fluctuations in interest rates.

Example: Suppose an Indian company has taken a loan of ₹ 100 crore from a bank on which it has to pay 9% fixed interest every year. But the company feels that floating rates will remain low in the future, so it does a swap deal with a bank in which it starts paying at a floating rate (eg MIBOR + 1%) instead of a fixed rate. This allows the company to take advantage of a possible fall in interest rates.

2. Currency Swap

In this, two parties exchange the principal and interest of loans taken in different currencies. These swaps are especially done when a company has to borrow in foreign currency but wants to avoid risk.

Example: An Indian company has taken a loan from the US in USD but it is easier to pay in rupees in the future. So it does a currency swap with an American company – the Indian company pays in dollars, and the American company in INR. This saves both parties from risk by paying in their respective country’s currency.

3. Commodity Swap

In this swap, two parties make payments based on mutually agreed price and market price of a commodity such as oil, gas, or metal. This is done to protect against price uncertainty.

Example: Suppose an Indian airline company needs 1 lakh liters of jet fuel every month. It fears that oil prices may rise in the future. It does such a swap with an oil supplier in which a fixed price (eg ₹ 85 per liter) is fixed every month, whether the market price is ₹ 90 or ₹ 75. This gives it stability in the budget.

4. Credit Default Swap (CDS)

This is a contract in which one party promises to compensate the other party in case of default of a loan or bond. This is a kind of “credit insurance”.

Example: Suppose an Indian bank has given a big loan to a real estate company. It fears that the company may go bankrupt. The bank takes CDS from an insurance company. Now if that real estate company does not repay the loan, the insurance company will compensate for the loss.

5. Equity Swap

In this, two parties make payment based on the return of the stock market and a fixed interest rate. In this, actual shares are not purchased, only the return is transacted.

Example: Suppose an Indian mutual fund wants a return of Nifty 50 but does not want to buy shares directly. It does an equity swap with a bank in which the bank gives it a return of Nifty 50, and in return the fund gives fixed interest (eg 7%).

Benefits of Using Swap Derivatives 

• Protection from interest rate risk : Swaps allow switching between fixed and floating rates, allowing companies to hedge their expenses against interest rate fluctuations.
• Control of currency risk : Currency swaps help manage the exchange rate risk associated with foreign currency loans or liabilities.
• Cost reduction : Swaps with more favourable terms can help organizations reduce their financing costs and improve cash flow.
• Customised financial strategy : Swaps can be customised, allowing companies to control their balance sheet risk in a customised way.

Risks Involved in Swap Derivatives

• Counterparty Risk : Swap derivatives are often over-the-counter (OTC), that is, they are traded directly between two parties rather than through an exchange. In such a situation, if one party does not fulfill the terms of the contract (defaults), then the other party can suffer huge losses. This risk increases further, especially in long-term swaps.
• Liquidity Risk : Swap contracts are highly customized, which makes it difficult to sell them in the secondary market or exit them prematurely. This is why the investor or institution has to remain in it for the entire period, even if the market conditions change.
• Valuation Risk : Since swaps do not have a uniform market price, valuing them is challenging. Complex financial models and assumptions are required to mark them to market. Valuation based on incorrect estimates can lead to huge losses.
• Regulatory Risk : After the 2008 financial crisis, derivatives regulations have been tightened around the world. In India, there has been increased oversight of OTC derivatives by RBI and SEBI. Many swaps now need to be settled through a clearing house, increasing the regulatory burden and reporting.
• Market Risk : Swap contracts depend on market-linked factors such as interest rates, currency rates, or commodity prices. If these change suddenly or unfavorably, it can expose the parties to huge losses. Without the right hedging strategy, this risk can be huge.

Why Do Investors and Institutions Use Swaps?

• Risk Management : The most common use of swaps is to protect against fluctuations in interest rates, currency rates or commodity prices. This helps companies stabilize their future payments.
• Speculative Use : Some professional traders use swaps to bet on the direction of the market, such as whether interest rates will rise or fall. In this, a position can be taken without buying the actual asset.
• Arbitrage Opportunities : When there is a price difference in two financial markets, investors can take advantage of low cost and high returns through swaps.
• Balance Sheet Management : Banks and corporate entities use swaps to improve their asset-liability matching and cash flow structure.
• Customised Financial Structure : Swaps are completely customisable, allowing companies to design them to suit their needs and precisely control risk.

Conclusion

Swap derivatives have become an essential tool in today’s complex financial environment for managing interest rate risks, foreign exchange volatility, etc. They are different from traditional derivatives because they are completely customizable. Although they come with risks, but with the right strategy and understanding, they can be very beneficial for institutions and experienced investors. It is important to examine them closely and seek professional advice before using them.

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