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NISM-Series-X-A: Investment Adviser (Level 1) · Understanding Derivatives

Swaps and Other Derivative Instruments Explained

Updated 11 October 2026 · Fact-checked

A swap is a contract in which two parties agree to exchange cash flows on set dates, based on a notional amount. In an interest rate swap, one pays fixed and the other pays floating. To solve questions, find who pays what, net the two flows, and apply them to the notional.

Understand Swaps and Other Derivative Instruments

A swap is a private agreement between two parties to exchange cash flows over a period. The cash flows are worked out from a notional principal. The notional is only a base for the calculation. It is usually not exchanged in an interest rate swap.

The most common swap is the plain vanilla interest rate swap. One party pays a fixed rate and receives a floating rate. The other does the reverse. Only the net difference is paid on each date. Example: a company has a floating-rate loan and fears rising rates. It enters a swap, pays fixed and receives floating. The floating receipt offsets its loan interest, so its cost is effectively fixed.

A currency swap exchanges cash flows in two different currencies. Unlike the interest rate swap, principal amounts are often exchanged at the start and the end. Swaps are over-the-counter (OTC) contracts. They are tailor-made, so they carry counterparty (credit) risk. In India, interest rate derivatives such as OTC swaps linked to benchmarks like MIBOR are used by banks and corporates.

Futures differ from swaps in key ways. Futures are standardised and traded on exchanges, with a clearing corporation guaranteeing trades and daily margining. Swaps are customised, negotiated privately, and carry counterparty risk. A swap is also a series of exchanges, while a futures contract settles at one expiry date.

Currency derivatives let you hedge exchange rate risk. In India, exchange-traded currency futures and options are available on pairs such as USD-INR on recognised exchanges. They are settled in rupees. Importers fear a weaker rupee and may buy USD futures. Exporters fear a stronger rupee and may sell them.

Other instruments include warrants and structured products. A warrant gives the holder the right to buy shares at a fixed price before a set date. Warrants are typically issued by the company and are longer dated than exchange-traded options. A structured product bundles a debt component with a derivative component, such as a market-linked debenture whose return depends on an index.

Key formulas to remember

Net swap payment per period
Net = Notional × (Floating rate − Fixed rate) × (days ÷ 365)
Positive means the fixed-rate payer receives. Negative means the fixed-rate payer pays. Many questions use a simple annual or half-yearly fraction, so follow the period given.
Fixed-rate payer view
Fixed payer gains when floating rate > fixed rate
Fixed receiver gains when floating rate < fixed rate.
Gain on hedge for importer using USD long
Gain = (Spot at expiry − Contract rate) × Contract size in USD
Positive when the rupee weakens against the dollar.
Swap versus futures rule
Swap = OTC, customised, counterparty risk; Futures = exchange-traded, standardised, margined
This is the usual comparison tested.

How to solve Swaps and Other Derivative Instruments questions

Use this method for any swap or instrument question, whether it is conceptual or numerical.

  1. 1Identify the instrument: swap, currency future or option, warrant or structured product.
  2. 2Note whether it is OTC or exchange-traded. This decides credit risk and standardisation.
  3. 3For a swap, mark who pays fixed and who pays floating.
  4. 4Compute each leg on the notional for the stated period, using the period fraction in the question.
  5. 5Net the two legs. Say who pays whom.
  6. 6For currency questions, decide whether the user is hurt by a weaker or stronger rupee, then pick the hedge.
  7. 7Check the answer against the options and remove any that mix up fixed and floating or swap and futures.

Quickest way: Fixed-versus-floating shortcut

When to use it: Use for any numerical swap question with a fixed and a floating rate.

  1. Subtract the fixed rate from the floating rate.
  2. If positive, the fixed payer receives. If negative, the fixed payer pays.
  3. Multiply the difference by notional and the period fraction.
  4. For concepts, remember: swaps are OTC with credit risk, futures are exchange-traded and margined.

Common mistakes in Swaps and Other Derivative Instruments

  • Thinking the notional principal is exchanged in an interest rate swap.

    Currency swaps do exchange principal, so the two get mixed up.

    Fix: In a plain interest rate swap, only net interest is paid. Principal exchange is typical of currency swaps.

  • Paying the full fixed and floating amounts instead of the net.

    Students treat each leg as a separate payment.

    Fix: Net the legs and show only the difference moving.

  • Reversing who gains when rates rise.

    Confusion between payer and receiver of fixed.

    Fix: Rates up means floating rises, so the fixed payer gains. Rates down favours the fixed receiver.

  • Calling swaps exchange-traded with a clearing guarantee.

    Swaps are grouped with futures under derivatives.

    Fix: Swaps are OTC and customised. Counterparty risk is a key feature.

  • Treating a warrant as the same as a listed option.

    Both give a right to buy at a fixed price.

    Fix: Warrants are issued by the company and are usually longer dated. Exchange-traded options are standardised contracts.

  • Picking the wrong currency hedge direction.

    Students forget whether the party pays or receives dollars.

    Fix: Ask who loses if the rupee moves. An importer with a dollar payment fears a weaker rupee.

Worked examples

Example 1

A company pays a fixed rate of 7% and receives a floating rate on a notional of ₹10,00,00,000. For one year the floating rate is 8%. What is the net settlement for the year, assuming a simple annual period?

Show the solution
  1. Fixed leg paid = 7% × ₹10,00,00,000 = ₹70,00,000.
  2. Floating leg received = 8% × ₹10,00,00,000 = ₹80,00,000.
  3. Net = ₹80,00,000 − ₹70,00,000 = ₹10,00,000.
  4. Floating is higher than fixed, so the fixed payer receives.

Answer: The company receives a net ₹10,00,000.

Example 2

Which statement correctly distinguishes a swap from a futures contract? (A) Both are standardised and exchange-traded. (B) A swap is customised and OTC with counterparty risk, while a futures contract is standardised and exchange-traded. (C) A swap is guaranteed by a clearing corporation and futures are not. (D) A swap always settles on one date and futures settle periodically.

Show the solution
  1. Recall that swaps are negotiated privately and tailored to the parties.
  2. Futures are standardised, traded on exchanges and backed by a clearing corporation with margins.
  3. Option A is wrong because swaps are not standardised.
  4. Option C reverses the guarantee.
  5. Option D reverses the settlement pattern, as swaps involve a series of exchanges.

Answer: Option B is correct.

Exam tips

  • Expect comparison questions on swaps versus futures. Learn OTC versus exchange-traded and counterparty risk first.
  • For numerical swap questions, write the fixed and floating legs separately before netting.
  • Watch the wording: a payer of fixed gains when floating rises.
  • With negative marking of 25% of the marks for the question, skip a swap question only if you cannot rule out at least two options.
  • Know one-line definitions of warrants and structured products, as they are often asked as definitions.

Practice questions from Understanding Derivatives

Swaps and Other Derivative Instruments in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Swaps and Other Derivative Instruments: frequently asked questions

What is an interest rate swap in simple words?

It is an agreement where two parties swap interest payments on a notional amount. One pays a fixed rate and the other pays a floating rate. Only the net difference changes hands.

What is the difference between swaps and futures?

Swaps are private, customised OTC contracts with counterparty risk. Futures are standardised, exchange-traded and backed by a clearing corporation with margining.

Are currency derivatives available in India?

Yes. Currency futures and options on pairs such as USD-INR trade on recognised exchanges and settle in rupees. Importers and exporters use them to hedge exchange rate risk.

What is a warrant?

A warrant gives the holder the right to buy shares at a fixed price before a set date. It is typically issued by the company and is longer dated than exchange-traded options.