A swap is a derivative contract where two parties agree to exchange cash flows or liabilities from different financial instruments over a set period of time. In the other words, a ‘Swap’ is an act of exchanging one thing for another. In derivative market, currencies swap, interest rates swap or commodities swaps are most common.
The swap can be based on a variety of underlying instruments, such as exchange of currencies, commodities, equities, or bonds. Swaps are traded over-the-counter (OTC), which means they are negotiated directly between the two parties
Currency Swap: When buying and selling of a foreign currency with different delivery dates simultaneously take place, it is called SWAP transaction. Currency swaps are used to hedge interest rate risk and exchange rate risk of a currency.
Commodity swap: In commodity swap, underlying commodity is traded for a fixed price at a different delivery date over a specified period.
Interest rate swap: In Interest Rate market (IRS), investors take a view on fall or rise in interest rates and enter into a transaction with another party having the opposite view. Any fluctuation in the interest rate on post contract will be a profit or loss to the holder depending on their position in the IRS. IRS is primarily a hedging tool for portfolio investors.
Initially, in the interest rate swap market, banks and bond houses used to cut deals covering the risk from rate fluctuations. In May 2016, Reserve Bank has allowed institutional entity regulated by RBI, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority of India, the Pension Fund Regulatory and Development Authority and the National Housing Bank to trade in interest rate swaps on electronic trading platforms. With the above permit, more institutional investors like Insurance companies will now participate in Interest Rate Swap.
Swap margin: Swap margin is the discount or premium between the spot rate and the forward rate for a currency/commodity.
Uses of Swaps:
Swaps are used by investors to hedge against potential risks. They can also be used for speculative purpose or companies may use swaps to reallocate their capital structure
