Unit 5: Swaps and other derivatives
Financial Swaps
A Swap is a derivative contract through which two parties exchange cash flows or other financial instruments over a set period. The most common swap is the interest rate swap, where fixed and floating interest rates are exchanged.
Key Features
- Involves two parties (counterparties)
- Based on a notional principal (no actual exchange of principal)
- Used for hedging or speculation
- Traded over-the-counter (OTC)
Types of Swaps
Swaps vs Derivatives
Real-Life Example
Interest Rate Swap Example:
- Company A has a loan with fixed 8% interest.
- Company B has a loan with floating LIBOR + 2%.
- Both companies want to exchange their interest types.
They enter into a swap contract to exchange interest payments.
Why Use Swaps?
Managing Interest Rate Exposure
Interest Rate Exposure refers to the risk of financial loss due to fluctuating interest rates.
Who is affected?
- Companies with floating-rate loans
- Investors holding fixed-income securities
- Banks & Financial Institutions
How to Manage It:
Interest Rate Swaps (IRS)
An Interest Rate Swap is an agreement between two parties to exchange interest payments — typically one pays a fixed rate, the other pays a floating rate.
Objective
- Hedge against interest rate movements
- Reduce borrowing costs
Example: Company A pays fixed 8%, wants floating, Company B pays floating (LIBOR + 1%), wants fixed
They swap interest payments based on a notional amount.
Currency Swaps
A Currency Swap is a contract to exchange principal and interest payments in one currency for those in another currency.
Objective
- Hedge foreign exchange risk
- Raise funds in a desired currency
Example
- Indian company borrows in USD, repays in INR
- US company borrows in INR, repays in USD
- They swap their currency payments.
Forward Rate Agreement (FRA)
An FRA is an OTC contract to lock in an interest rate for a loan or deposit that will occur in the future.
Key Features
- Settled in cash (no actual loan)
- Based on notional principal
- Used to hedge against future interest rate changes
Example
- A firm expects to borrow ₹10 Cr in 3 months for 6 months.
- It enters an FRA to fix the interest rate at 6.5%.
If the actual rate goes higher, it gains on the FRA; if lower, it loses — but net borrowing cost stays stable.
Comparison Table
