Swaps

A swap is a simultaneous buying and selling of the same security or obligation. Interest rate
swaps are fairly common in which two parties exchange identical securities having different
interest rate structures. The swap market has grown dramatically. Today Swaps involve
exchange of other than interest rates, such as mortgages and currencies. Swaps may also
include Caps and Floors or Caps and Floors combined Collars. A derivative
consisting of an option to enter into an interest rate swap, or to cancel an existing swap in
the future is called a Swaption

Swaptions
Swaptions are options to buy/sell a swap that will become operative at the expiry of the
option. Thus a swaption is an option on a forward swap. Rather than having calls and puts,
the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and pay floating, whereas a payer swaption is an option to pay fixed
and receive floating.

Differences between spot contract and forward contract

1. In a spot contract, at least one component, i.e. either the price or the goods/ services is tendered at the
time of the contract. In a forward contract, both the components are exchanged at a specified future date.
2. In a spot contract, both the parties transact on the basis of their present capability. The buyer
purchases according to his ability to pay for the goods or services and the seller sells according to his
present ability to deliver the goods or services. In a forward contract, a leveraging of capabilities is
involved. Since no down payment is involved, the buyer might contract to buy a larger number of goods or
services, expecting to derive some benefits from the perceived price differential between the spot price
and the likely price at the time of maturity of the forward contract. Also the seller, feeling that a larger
number of goods shall be available at the contracted price at the time of maturity, agrees to sell a far
larger number of goods.
3. In a spot contract, execution of the contract is more or less certain because both the
components, i.e. money and goods are available. Even through the transaction does not
pass through a regulated delivery and payment mechanism yet the chances of default are
very less. The problems of payment and delivery get magnified in the case of a forward
contract.

Advantages of forward markets

In spite of the problems of the forward contracts described above, there are two important contributions of
these contracts.
(a) Forward contracts are useful hedging tools
Hedging is a process of risk management under which the risks emanating from a transaction are
covered or mitigated. So, when the farmer enters into the forward contract with bakery owner for selling
50 tonnes of wheat six months hence, he is hedging against the decline in price. The bakery owner, on
the other hand, is hedging against the lack or shortage of supply. Both of them are trying to create a
certain future for themselves as far as this transaction is concerned. Viewed in this background, forward
contracts are excellent means of hedging against price risk and quantity risk.
(b) Forward contracts help in price discovery
The time gap between signing or formulation of a forward contract and its execution gives
rise to uncertainty. From this uncertainty is born speculation regarding future price of the
goods and services. Assuming that both the seller and the buyer have near perfect

information about future price of the goods and services, the forward contract may be
considered as an appropriate means of their price discovery.