What Is Swap – Financial Derivatives Used In Risk Management

Key Takeaways

• A swap is an agreement between two entities in which they exchange cash flows or liabilities.
   
• Swaps are used by the entities as they help in stabilising interest payments, managing currency exposure, giving access to cheaper funds, and many more. 
   
• The main types of swaps are interest rate swaps, currency swaps, commodity swaps, and equity swaps. These different types of swaps solve the different problems of the company.  

A swap is a contract between two parties that agree to switch cash flows over a specified period. This is usually based on interest rates, currencies, commodities, or equity returns. The key aim is to reduce risk or to make borrowing and investment more cost-effective.

Suppose company ABC issues ₹80 crore bonds for two years at a floating rate of MCLR + 1%. With MCLR at 7%, the cost is 8% or ₹6.4 crore annually. The company fears MCLR may rise, which would increase its payments.

To reduce this risk, it entered a swap agreement with Company XYZ. Under the agreement, Company ABC pays a fixed 9% on ₹80 crore, and Company XYZ pays MCLR + 1%. If MCLR rises, then company ABC benefits by paying fixed interest. However, if they fall, then company XYZ will benefit.

MCLR is the minimum lending rate below which banks are not permitted to lend.

In this blog, we will learn more about swaps and why companies, banks, and investors use swaps.

Why Are Swaps Used?

Swaps help a company in cost saving, hedging, and making cash flows predictable. The following table highlights why swaps are used:
 

From the above-mentioned table, you can see that swaps also help a company in improving efficiency in borrowing, lending, and investing. 

Types Of Swaps In Financial Markets

There are different types of swaps, and each type has its own risk or financial need. The following table highlights the main types of swaps in the financial markets:
 

From the above-mentioned table, you can see that each type of swap solves a different challenge faced by the companies. 

Bonus Tip: In finance, a plain vanilla swap is the simplest form, where fixed interest payments are exchanged for floating ones. It highlights how basic this is compared to the many complex and customised swaps available.

Risks Related To Swaps

Swaps are over-the-counter (OTC) contracts (they are customised agreements between two parties and not traded on an exchange). This creates some risks for the companies. The following table highlights the main risks related to swaps:
 

Company A enters into a ₹50 crore interest rate swap, expecting ₹3 crore annually from Company B. If B defaults due to insolvency, A loses this receivable and may face replacement costs.

Market Risk

Unfavourable shifts in interest rates, commodity prices, or currencies can turn a swap unprofitable.

A firm pays a fixed 9% but receives floating MCLR + 1%. If MCLR falls to 6%, the inflow is 7% while the outflow remains 9%, creating a negative spread.

Liquidity Risk

Swaps cannot be easily transferred or traded, and unwinding a position before maturity often requires negotiation.