What are Derivatives Swaps?

Justin Riche
Justin Riche
Businessman with a briefcase
Businessman with a briefcase

Derivatives swaps are financial products that are mainly used to exchange/swap payment terms, risks or anything else tied to certain assets. In transactions that involve derivatives swaps, the assets in question are not necessarily exchanged or swapped. The widely used types of derivatives swaps include a credit default swap (CDS), an interest rate swap, a currency swap, a total return swap (TRS) and a commodity swap.

Interest rate swaps allow parties to exchange or swap the types of interest payments that are tied to a particular notional amount. To illustrate one type of interest rate swap, consider an individual who has borrowed $1 million US Dollars (USD), on which she pays a variable rate of interest. Another party, also has borrowed the same amount of money, but he pays a fixed-rate of interest. For whatever reason, the first individual would prefer to pay a fixed-rate of interest, and the second desires to make his interest payments at a variable rate. To achieve their respective goals, they can enter into a customized interest rate swap agreement with each other.

The main purpose of a CDS is to transfer risk from one party to another, and in theory, it is designed to work in a similar fashion to that of an insurance policy. A CDS is designed to protect those who lend money from the financial risk of default by those who have borrowed the money. When people borrow funds, they might get into financial trouble in the future and become unable to repay the loan. This is the reason why those who lend money will buy a CDS in order to protect themselves from risk of financial loss. Normally, a CDS will be purchased from a third party who is willing to assume the risk, and this party will receive regular premiums from the buyer, more or less like in an insurance situation.

In a currency swap transaction, two parties make a deal to swap payments that are based on different currencies. This type of deal also usually requires that a certain amount of different currencies is exchanged, normally at the current exchange rate. Moreover, the regular interest payment based on the currencies can be either a variable rate or fixed rate of interest payment, as per agreement between the parties. At the end of the contract period, the amounts of different currencies that were initially exchanged are returned, but any gains made on the interest payments are kept by the parties.

The payments in derivatives swaps involving commodities are tied to the value of particular physical commodities. These deals are mostly customized just like other types of swaps. In a commodity swap involving oil, for instance, two parties can agree on a particular amount of oil to be exchanged at a specific price for a determined time period. For example, an airline company might make a deal with an oil supplier to purchase 2 million barrels of oil at $50 USD per barrel each year for a five-year period. This allows the two parties to lock in a desired price, and both of them are contractually obligated to meet their side of the bargain as their contract states.

Total return swaps are types of derivatives swaps that allow investors to benefit from bank loans and bonds, and other similar products without buying the underlying assets. The bank loans, bonds and the other products are the underlying assets from which the value of the total return swaps are based. Furthermore, the activity of buying derivatives and/or selling derivatives is normally achieved in two ways, which are over-the counter (OTC) deals or through an exchange, such as the futures exchange and options exchange. Derivatives swaps are mostly done in OTC deals that are highly customized between the parties involved. There are, however, some exchange-traded swaps.

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