A derivative denotes a contract between two parties, with its value generally determined by an underlying asset's price. Common derivatives include futures contracts, options, forward contracts and swaps. Swaps comprise one type of the broad derivatives universe but its value isn't derived from an underlying security or asset.
The Difference Between Derivatives and Swaps
The value of derivatives are generally derived from the performance of an asset, index, interest rate, commodity or currency. For example, an equity option, which is a derivative, derives its value from the underlying stock price. In other words, the value of the equity option fluctuates as the price of the underlying stock fluctuates.
Swaps are agreements between two parties, where each party agrees to exchange future cash flows, such as interest rate payments. Contrary to other derivatives, swaps do not derive their value from an underlying security or asset.
Explaining Interest Rate Swap
The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties agree to exchange interest payments. For example, assume Bank A agrees to make payments to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A based on a floating interest rate.
Assume Bank A owns a $10 million investment that pays the London Interbank Offered Rate (LIBOR) plus 1% each month. Therefore, as LIBOR fluctuates, the payment the bank receives will fluctuate. Now assume Bank B owns a $10 million investment that pays a fixed rate of 2.5% each month.
Assume Bank A would rather lock in a constant payment while Bank B decides it would rather take a chance on receiving higher payments. To accomplish their goals, the banks enter into an interest rate swap agreement. In this swap, the banks simply exchange payments and the value of the swap is not derived from any underlying asset.
Swap Risks
Interest rate risk is significant because interest rates do not always move as expected. Both parties have interest rate risk. The holder of the fixed rate risks the floating interest rate going higher, thereby losing interest that it would have otherwise received. The holder of the floating rate risks interest rates going lower, which results in a loss of cash flow since the fixed rate holder still has to make streams of payments to the counterparty.
The other main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the floating rate is unable to make payments under the swap agreement, the holder of the fixed rate has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed rate was seeking to avoid.
Legislation passed after the 2008 economic crisis requires most swaps to trade through swap execution facilities as opposed to over the counter, and also requires public dissemination of information. This market structure is intended to prevent a ripple effect impacting the larger economy in case of a counterparty default.

How do companies benefit from interest rate and currency swaps?
Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >> 
How does an entrepreneur choose a business structure?
Learn more about interest rate swaps and currency swaps, how these swaps are used and the difference between interest rate ... Read Answer >> 
What is a Debt for Equity Swap?
Learn why companies issue debt for equity swaps, what they are, and how they impact shareholders and debt holders. Read Answer >> 
What kinds of derivatives are types of forward commitments?
Learn more about what a derivative is, what a forward commitment is and which types of derivative securities have forward ... Read Answer >>

Managing Wealth
An InDepth Look at the Swap Market
The swap market plays an important role in the global financial marketplace; find out what you need to know about it. 
Investing
What's an Interest Rate Swap?
An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount. 
Trading
How To Value Interest Rate Swaps
An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time. 
Trading
Currency Swap Basics
Find out what makes currency swaps unique and slightly more complicated than other types of swaps. 
Trading
Derivatives 101
Learn how to use derivatives to hedge, speculate or increase leverage in an investment portfolio. 
Investing
CFTC Probes Banks' Use of Interest Rate Swaps
U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis 
Investing
PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)
Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings. 
Investing
The Advantages Of Bond Swapping
This technique can add diversity to your portfolio and lower your taxes. Find out how. 
Trading
Hedging with currency swaps
The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it with currency swaps. 
Managing Wealth
Managing interest rate risk
Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate and directly affects the values of fixedincome securities.

Liability Swap
A liability swap is a financial derivative in which two parties ... 
Forward Swap
A forward swap is an agreement between two parties to exchange ... 
Floating Price
The floating price is a leg of a swap contract that depends on ... 
Swap Rate
The swap rate is the fixed portion of a swap as determined by ... 
Swap Curve
A swap curve identifies the relationship between swap rates at ... 
Delayed Rate Setting Swap
A delayed rate setting swap is an exchange of cash flows, one ...