What are Swaps Derivatives?

What Are Swaps Derivatives?

Swaps derivatives came into the Indian market in the late 1980s but quickly gained prominence due to their simplicity and returns. In fact, swaps derivatives are some of the most commonly traded financial contracts in the Indian capital market. 

Unlike futures and options, Swap contracts take place between two parties Over-The-Counter (OTC). It empowers two parties to enter into a financial agreement through which they can exchange their liabilities or cash flows. Through swap contracts, a party promises to pay some money for receiving some money from the second party. The basic premise of swaps derivatives is notional principal amounts, such as from bonds or loans. 

A swap contract usually contains things like the swap start and end date, the nominal amount, payment frequency, margin or interest rate, and the Index of Reference. 

What is the Difference Between Futures/ Options and Swaps Derivatives?

A futures/options contract enables you to buy or sell an underlying asset at a pre-decided price on a future date. Since the futures contracts get their value from an underlying asset, it is known as derivatives. Futures and options are standardised contracts traded through stock or commodity exchanges, such as the National Stock Exchange (NSE), Multi Commodity Exchange (MCX), and the like. 

Unlike futures and options, swaps derivatives are not traded through stock exchanges. Instead, they are Over-The-Counter (OTC) instruments. To enter into a Swap Contract, two parties (a.k.a. counterparties) meet and decide to trade securities. The transaction is neither governed nor monitored by stock exchanges like NSE, MCX, etc. Swap contracts change hands through decentralised dealer networks with no physical location. Generally, the counterparties in swap derivatives are financial institutions and large companies, not individuals. This is because the risk of counterparty default is always high in swaps derivatives. 

What Are The Most Common Types of Swaps?

The following are the most popular types of swaps you can trade in the Indian capital market:

1. Interest Rate Swaps

In interest rate or plain vanilla swap contracts, the counterparties exchange their cash flows to hedge against interest rate risks. They can also use this to speculate and profit. The cash flows depend on a notional principal amount agreed by both parties. But, the amount is not exchanged initially. Interest rate swaps are the most commonly traded swaps in the Indian capital markets. 

2. Commodity Swaps

A commodity swap contract has two components- floating leg and fixed leg. Through this, the counterparties exchange a floating commodity. The floating leg is linked to an underlying commodity’s market price, whereas the fixed leg refers to the floating rate offered by the commodity’s producer. Crude oil is the most commonly traded commodity swap in the world.

3. Currency Swap

Through a currency swap contract, the counterparties exchange the principal and the interest on the debt. A currency swap is typically denominated in different currencies. Currency swaps are a classic hedging instrument, and investors use this to protect their capital from the fluctuations in currency exchange rates.

While Swaps Are For The Experts, Futures and Options Are For Anyone

After going through this article, you must have understood that although swaps derivatives are very popular, they are not as liberally available to retail investors as futures and options. 5paisa provides a free Demat and trading account to give you the right beginning in the capital market. Open an account now to experience unparalleled convenience and real-time price quotes.