Swap Contracts – Overview, Types and Applications

1. What is a Swap?

Swap contracts are OTC contracts which means that they are traded Over the Counter. These are not standardized contracts are therefore are not traded on the exchanges. These contracts are between two parties and involves exchange of pre-agreed cash flows of two financial instruments, where each stream of the cash flow is referred to as a leg.

Swaps were introduced in the late 1980s and are relatively new. However, their simple nature and extensive applications makes them one of the most frequently traded derivatives contracts.

Swap contracts are used by corporate finance professionals for hedging risk and minimizing the uncertainty of certain operations. For example, a currency swap contract can be used for hedging a project which is exposed to the exchange rate risk.

There are some financial institutions which are involved in the swap market and are known as the market makers. These institutions are swap banks and facilitate swap transactions by matching counter parties.

2. Types of Swaps

There are different types of swap contracts available in the modern financial market. Let us discuss about some of the most popular type of swap contracts.

Interest Rate Swap: In this contract, both the parties agree for exchanging one stream of future interest payments for another. This exchange is usually based on a predetermined notional principal amount. These contracts are usually used for exchanging flat interest rate with a floating interest rate.

Currency Swap: In this type of Swap, both the parties exchange the principal amount and interest payment which are denominated in two different currencies. These contracts are used for hedging investment positions against the currency exchange rate movements and fluctuations.

Commodity Swap: These Swaps are used for exchanging floating cash flows based on the spot price of a commodity for fixed cash flows determined by a preset price of a commodity. There is no exchange of actual commodity in commodity swaps.

Credit Default Swap: These Swaps are used as an insurance against the default of a debt instrument. In this contract, the swap buyer transfers the premium payments to the seller. In a condition, where the asset defaults, the seller will reimburse the face value of the asset to the buyer and the asset will be transferred to the seller from the buyer.

3. Applications of Swap

Swaps have a number of applications in the modern financial markets. Some of the major applications of swaps include:

Risk Hedging: This is the first and foremost application of a swap. For instance, currency swaps can be a good way to hedge against currency exchange fluctuations, interest rate fluctuations can be hedged by interest rate swaps.

Access to new markets: With the help of swaps, you can access previously unavailable markets. For example, an Indian investment company can enter into a currency swap with a US based company to access the USD-INR exchange rate, because the US company will be able to borrow domestically at a lower rate.

Swaps have a number of different applications as well depending on the counter parties involved in entering in the contract,

While Swap contracts are not available easily for the retail investors, they do carry a high amount of risk associated with them. Therefore, if you are not an institutional investor it is recommended to invest in other derivative contracts. You should get your risk profile evaluated from a SEBI registered investment advisor before investing in any of the investment instruments to have an idea about your risk bearing capacity.Happy Trading!