Swaps are a kind of derivative. Let us recall what derivative is i.e. derivative is a kind of financial instrument that derives its value from an underlying asset. The underlying asset could be the interest rate, time, etc. These were initially introduced with the objective to reduce or mitigate the risk of a concerned party and also include forward, futures, warrants, and swaps are one of them.
Swaps basically refer to multiple interest rates and we would be seeing how swaps are a great financial instrument and also stabilizes our returns in the following examples. Like in derivatives there are three kinds of users i.e. hedgers, speculators, and arbitrageurs. Under swaps, there is no money exchange between the parties but the rate of interest is being exchanged. For example, there is a contract between two parties worth $1000 so this money is not being paid but it is taken as a reference value for interest calculation and is thus known as notional value. The two parties involved are the payer and receiver. Let us say the payer is to pay the receiver interest of Libor(L)+2 for three years and in return the receiver will pay the payer flat interest of say 10%.
It might sound a bit complex and futile to just take money for reference and to pay interest and receive some but helps in reducing the risk. For example, we have borrowed money from the bank and are supposed to pay interest of L+2 and we think that according to the current market conditions the L will increase, and thus it will be a loss to us. We can reduce our risk by entering into swaps. Let say we borrowed a loan of $1000 and interest is L+2. We entered into swaps with a notional value of $1000. We are supposed to receive l+2 and have to pay a flat 7%. Thus whatever money we will receive will be paid on the loan thus reducing the risk of an increase in labor rate and thus finally have to pay flat 7% in return.
This is an example of hedging in swaps.
Another example of hedging under swaps is when we want to convert our floating rate on bonds to a fixed one. Let us see how it works. Say we have purchased bonds worth $100 and the interest we receive is floating i.e. L+1. We have evaluated the market conditions and think that that labor will decrease from say 8% to say 5% thus our income will reduce. To reduce or mitigate the risk we can enter into swaps to change our floating return to fixed return. Say we entered into swaps thus notional value will be $100 and we are supposed to pay L+1 and in return will receive 10%. Thus whatever money we will receive from bonds will be paid in swaps and our income will be fixed at 10% thereby reducing our risk.
But since every coin has two sides swaps may sound effective instrument but its applications are difficult though it reduces our transaction cost, tax liabilities, etc but also leads to reduces profitability profits. Thus its application should be made judiciously and only after proper evaluation of the market conditions only.