Swaps in Finance - What Is It & Types

In finance, swaps are derivative contracts between two parties. As part of their agreement, both parties will exchange earnings on separate financial instruments. In addition, only the cash flows are exchanged, while the principal amount remains with the original parties. Cash flow exchanges are known as 'legs'. A swap contract involves an underlying asset, such as a legal commodity or financial instrument. Such contracts are usually entered into by big businesses and financial institutions. However, retail investors rarely engage in swap transactions. After understanding what is swap in derivative market, let’s learn the types of swaps.

Types of Swaps

The following are the swap types:

1. Interest Rate Swap

Interest rate swaps are a common type of swap contract where two parties, like X and Y, agree to exchange a fixed interest rate for a floating one. In this arrangement, X pays Y a predetermined fixed rate, while Y pays X interest at a variable rate. These interest payments occur at regular intervals throughout the contract to help both parties manage the risks associated with fluctuating interest rates. This is commonly referred to as a plain vanilla swap.

1. Commodity Swap

Commodity swaps involve producers and buyers fixing a selling price for a commodity, such as grains, crude oil, or metals. This arrangement helps mitigate potential losses caused by price fluctuations. The value of these commodities is determined at a spot price, which can be volatile.

1. Credit Default Swap

Credit-default swaps act like insurance for lenders against the risk of a borrower defaulting. A third party guarantees to pay the principal and interest to the lender if the borrower cannot repay. Thus reducing the lender's risk and making it easier for the borrower to secure loans. However, the swap is only activated in the event of a borrower default.

1. Debt Equity Swap

Debt-equity swaps are used to exchange debt for equity or vice versa, helping companies restructure their capital. Companies often turn to this option when they struggle to meet debt payments, opting for equity to ease repayment.

1. Total Return Swap

Total return swaps involve one party providing a fixed interest rate to the other, reducing the risk for the first party, while the second party benefits from price fluctuations, dividends, and share value appreciation.

1. Currency Swap

Currency swaps entail the exchange of loan amounts and associated interest rates in different currencies. Businesses use this to avoid foreign exchange taxes and obtain local currency loans easily. Governments also use these contracts to stabilise exchange rate fluctuations. For instance, the recent dollar-rupee swap auction announced by the RBI is an example of such a swap.

Conclusion

In finance, swaps are contracts that help two parties exchange cash flows without moving the original amount of money. Prior to trading, it is crucial for traders to understand derivatives, such as the uses and features of derivatives. You can learn about them in detail on portals of excellent platforms like BlinkX, which facilitate trading all kinds of derivatives. Swaps agreements are usually made by big businesses and financial institutions to handle risks related to financial instruments and commodities. Retail investors usually don't get involved in swap deals.

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