The one big similarity is that, both are forward contracts. But, the big and the really big difference is on the underlying asset.
Swaps do not follow any underlying asset, while derivatives track an underlying asset.
Derivatives are contracts involving two or more parties with a value based on an underlying financial asset. Often, derivatives are a means of risk management. Originally, international trade relied on derivatives to address fluctuating exchange rates, but the use of derivatives has expanded to include many different types of transactions.
Swaps are a type of derivative that has a value based on cash flows. Typically, one party’s cash flow is fixed while the other’s is variable in some way.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the “underlying“. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry.
Derivatives are contracts between two parties that specify conditions (especially the dates, resulting values and definitions of the underlying variables, the parties’ contractual obligations, and the notional amount) under which payments are to be made between the parties. The assets include commodities, stocks, bonds, interest rates and currencies, but they can also be other derivatives, which adds another layer of complexity to proper valuation. The components of a firm’s capital structure, e.g., bonds and stock, can also be considered derivatives, more precisely options, with the underlying being the firm’s assets, but this is unusual outside of technical contexts.
From the economic point of view, financial derivatives are cash flows that are conditioned stochastically and discounted to present value. The market risk inherent in the underlying asset is attached to the financial derivative through contractual agreements and hence can be traded separately. The underlying asset does not have to be acquired. Derivatives therefore allow the breakup of ownership and participation in the market value of an asset. This also provides a considerable amount of freedom regarding the contract design. That contractual freedom allows derivative designers to modify the participation in the performance of the underlying asset almost arbitrarily. Thus, the participation in the market value of the underlying can be effectively weaker, stronger (leverage effect), or implemented as inverse. Hence, specifically the market price risk of the underlying asset can be controlled in almost every situation.
A swap, in finance, is an agreement between two counterparties to exchange financial instruments or cashflows or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
The general swap can also be seen as a series of forward contracts through which two parties exchange financial instruments, resulting in a common series of exchange dates and two streams of instruments, the legs of the swap. The legs can be almost anything but usually one leg involves cash flows based on a notional principal amount that both parties agree to. This principal usually does not change hands during or at the end of the swap; this is contrary to a future, a forward or an option.
In practice one leg is generally fixed while the other is variable, that is determined by an uncertain variable such as a benchmark interest rate, a foreign exchange rate, an index price, or a commodity price.
Swaps are primarily over-the-counter contracts between companies or financial institutions. Retail investors do not generally engage in swaps.
Derivatives contracts can be divided into two general families:
- Contingent claims (e.g., options)
- Forward claims, which include exchange-traded futures, forward contracts, and swaps.
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.