Derivatives vs. Swaps: What's the Difference?

Derivatives vs. Swaps: An Overview

Derivatives are contracts that involve two or more parties. They have a value based on an underlying financial asset. Derivatives are often a means of risk management. International trade originally relied on derivatives to address fluctuating exchange rates but their use has expanded to include many different types of transactions.

Swaps are a type of derivative with a value based on cash flows. One party's cash flow is typically fixed while the other party's is variable in some way.

Derivatives

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.

The value of derivatives is generally derived from the performance of an asset, index, interest rate, commodity, or currency. An equity option is a derivative that derives its value from the underlying stock price. The value of the equity option fluctuates as the price of the underlying stock moves up and down.

A buyer and a supplier might enter into a contract to lock in a price for a particular commodity for a set period. The contract provides stability for both parties. The supplier is guaranteed a revenue stream and the buyer is guaranteed supply of the commodity.

The value of the contract can change if the market price of the commodity changes, however. The derivative value goes up for the buyer if the market price goes up during the contract period because they're getting the commodity at a price lower than the market value.

The derivative value would go down for the supplier. The opposite would be the case if the market price dropped during the period covered by the contract.

Swaps

Swaps are a type of derivative but their value isn't derived from an underlying security or asset.

The most basic type of swap is a plain vanilla interest rate swap. Parties agree to exchange interest payments. Assume Bank A agrees to make payments to Bank B based on a fixed interest rate. Bank B agrees to make payments to Bank A based on a floating interest rate.

Bank A owns a $10 million investment that pays the Secured Overnight Financing Rate (SOFR) plus 1% each month. The payment the bank receives will therefore fluctuate as SOFR fluctuates. Now assume Bank B owns a $10 million investment that pays a fixed rate of 2.5% each month. 

Bank A would rather lock in a constant payment while Bank B decides it prefers to take a chance on receiving higher payments. The banks enter into an interest rate swap agreement to accomplish their goals. The banks simply exchange payments in this swap. The value of the swap isn't derived from any underlying asset.

Interest Rate Risk

Both parties have interest rate risk because interest rates don't always move as expected. The holder of the fixed rate risks the floating interest rate going higher and losing interest that it otherwise would have received. The holder of the floating rate risks interest rates going lower, resulting in a loss of cash flow because the fixed-rate holder still has to make streams of payments to the counterparty.

Counterparty Risk

Counterparty risk is the other main risk associated with swaps. This is the risk that the counterparty will default and be unable to meet its obligations under the terms of the swap agreement. The holder of the fixed rate has credit exposure to changes in the interest rate agreement if the holder of the floating rate is unable to make payments. This is the risk the holder of the fixed rate sought to avoid.

The Bottom Line

Legislation passed after the 2008 economic crisis requires that most swaps trade through swap execution facilities rather than over the counter. It 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.