What are Swaps in Derivatives? Types, Features and Example

In the financial market, there are various instruments giving you varied opportunities to not only invest and multiply your money, but you can use the derivatives to protect your assets, existing funds to minimise the cost of borrowing. A swap is like one of them, a derivative contract giving an option to two parties to enter into such an agreement to exchange their liabilities through cash flow.

Though mostly the institutions, not the individuals use the swap but understanding the swap is very important to make the right use of such financial instruments. Hence, today in this article we are going to discuss about swaps in financial derivatives markets, how they work, features and types of swaps.

What are Swaps in Derivative?

Swap in derivatives is an agreement or type of OTC contract between two parties, allowing them to exchange their liabilities and cash flow for a specified period using various financial instruments. In a swap, the original or principal amount is not transferred; instead, only cash flows are exchanged.

The swap instrument can be anything that has financial value and is legal in the financial market. It can be loans, interest rates, exchange rates, currency or commodities. However, it is a customised financial instrument used as financial insurance and works as a hedge mechanism for institutions and corporations. Let’s find out how it works and what the top features of swaps in derivatives are.

How do Swaps Work in Finance?

Swap derivatives work with a mutual agreement between two parties to exchange their agreed financial obligations over a defined period. Though in India, mostly banks, financial institutions, institutional investors and companies use the swaps to manage the risks associated with interest rates, currencies and commodities.

Here, the original or principal amount, loan or investment is not exchanged; instead, the cash flow generated exchanged between the parties. It is traded in the open market through over-the-counter (OTC), but a few swaps, like rupee-USD currency swaps and interest rate swaps, are regulated by the RBI.

Features of Swaps in Derivatives

• Notional Principal: This amount is used as a reference to calculate the cash flow payments or interest, as the original principal amount is neither exchanged initially nor at the end of the contract.

• Traded Over-the-Counter: It is not traded publicly on any exchange or trading platform; it is a private agreement between two parties directly negotiated between them as per their mutual contract.

• Flexibility to Customise: The terms or conditions, including the notional amount, frequency of payments and duration of contract, can all be fully customised as per the needs and mutual agreement of the parties.

• Settlement: Here, the settlements take place in terms of paying the difference between the fixed and floating payments on agreed dates. No exchange of full cash or original principal amount.

• No Upfront Charges: To enter into such OTC contracts, no upfront fees or any other charges are paid.

• Specified Duration: The contracts are for a specified duration to exchange the cash flow. And the duration could be from a few months to several years, as per the mutual agreement between the two parties.

• Cash Flow Types: Usually, the swapping of fixed or variable interest rates or floating prices takes place.

Swaps Derivatives Example:

Let’s take one of the most common types of swaps – an interest rate swap that companies, institutions and even individuals use to hedge their credit expenses against changing interest rates.

Suppose two companies enter into a swap contract, in which company X has a loan with fixed interest rates 7%, while on the other hand, company Y has a loan with floating or variable interest rates at 5%.

Here, company X now prefer variable interest rates and expects the interest rates might change, while company Y prefer the stable rate of interest.

In the swap condition, company X agreed to pay the variable interest rate of company Y, while company Y agreed to pay company X’s fixed interest rate of 7%.

Here, if the variable rate of interest surged to 6%, company Y benefits by gaining the ability to pay a stable 5% despite the fluctuation in the interest rates.

However, if variable interest rates dropped to 4%, then company X will get the benefit of paying the lower interest rates. But both have the exposure to take advantages of change in interest rates without exchanging their principal amount or transferring their debts to each other.

>> Also Read: Understanding the Call Option

Types of Swaps in the Derivatives Market

The swaps in the derivatives market allow both companies to take advantage of interest rate fluctuations to manage their financial burdens. There are various types of swaps that different entities use to hedge their financial exposure or manage the risks in derivatives markets. 

Interest Rate Swaps

It is one of the most common types of swaps in the Indian financial market. In this type of swap, two counterparties enter into a swap contract to exchange their cash flow of interest rates to hedge against fluctuations. Though the cash flow is based on the notional principal amount agreed by both parties at a predetermined interest rate, here the amount is not exchanged at the start.

Currency Swaps

In this type of swap, both counterparties agree to exchange their interest as well as principal amount on loans or debts that are denominated in two different currencies. This allows the companies to hedge their investments or financial exposure against fluctuations in currency exchange rates. Apart from two companies, two different countries can also enter into currency swaps to hedge against exchange rate fluctuations. 

Credit Default Swaps

This swap is used to ensure against the risk of loan default by the borrower. Here, as per the swap contract, if a borrower is unable to repay the loan, then the third party guarantees to pay the interest as well as the principal to the lender. Here, the risk is reduced for the lender, allowing the borrower to easily avail the loan. But the swap contract comes into effect when the borrower defaults on the loan.

Commodity Swaps

This swap allows companies to protect themselves against the fluctuations in the prices of the various commodities like oil, gas, metals, agricultural supplies and other essential commodities. This type of swap helps companies to hedge their business exposure against the fluctuations in commodity prices, ensuring the supply of commodity products or energy resources at stable prices. 

Equity Swaps

This swap derivative instrument allows the investors to exchange returns of the equity market or stocks at a predefined period without actually owning the underlying assets. It helps investors looking to diversify their investment into the stock market through an equity index or stocks.

Debt-Equity Swaps

This type of swap is used to exchange the debt for equity or equity for debt as part of the financial restructuring of companies. The company wants to convert its debts into equity shares can enter into such a swap to restructure the burden on its financial balance sheet. However, such swaps usually take place during the debt settlement between the corporates and lenders or at the time of insolvency proceedings.

Total Return Swaps

In this swap, one party agrees to receive at the fixed or floating rates, while the other one pays through the returns earned from an underlying asset that includes interest, dividends and capital gains. This swap is used on stocks, bonds and indices with the benefit of passing the income from such assets without transferring the actual ownership of the asset.

Final Words

Swaps are a type of OTC contract between the counterparties to exchange their cash flows or liabilities without transferring the principal amount or the ownership of the underlying assets. It is generally used by the corporates, institutions, banks and financial companies to reduce their borrowing cost and manage the risks arising due to fluctuations in the financial markets.

The most common types of swaps include interest rate, currency, commodity, and credit default swaps that are customizable as per the terms and agreement between both parties for a specified period. There are no upfront charges, and settlement is done with the exchange of cash flow. It helps reduce the financial burdens and manage the risk due to rate fluctuations, changes in exchange rates or returns from assets.

• Author: Religare Broking
• Last Updated: April 1, 2026