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.
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.