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:
 

The above-mentioned table reflects that swaps protect companies against volatility, but they also carry risks. 

Final Thoughts

Swaps are widely used financial contracts that help companies manage exposure to interest rates, currencies, and other market variables. For example, interest rate swaps can stabilise borrowing costs, while currency swaps can make cross-border payments more predictable.

Though they involve risks such as counterparty and liquidity concerns, if you apply them carefully, then swaps support better cash flow planning and risk management. This practical utility explains why many businesses integrate them into their financial strategies.

FAQs

1. Why are swaps risky?

Swaps are risky because they involve counterparty default, market fluctuations, and high exit costs.

2. Why do brokers charge swaps?

Brokers charge swaps as overnight financing fees when positions are carried beyond a trading day.

3. Why do banks use swaps?

Banks use swaps to manage interest rate exposure, currency mismatches, and funding costs.

4. Who regulates swaps in India?

In India, the Securities and Exchange Board of India (SEBI) regulates swaps.

5. How long do swaps take?

Swaps usually last from a few months to several years, depending on the contract terms.

6. What is swap one?

Swap one refers to a single swap contract entered between two parties for hedging or trading purposes.

7. Who buys swaps?

Banks, companies, and investors use swaps,
 

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LoansJagat Team

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