Swap vs Forward
Derivatives are special financial instruments that derive their value from one or more underlying assets. The changes in movements, in the values of the underlying assets, affect the manner in which the derivative is used. Derivatives are used for hedging and speculation purposes. The following article takes a closer look at two types of derivatives, the swaps and forwards, and clearly highlights how each type of derivative is different and similar to one another.
Forward
A forward contract is a contract that promises delivery of the underlying asset, at a specified future date of delivery, at an agreed upon price stated in the contract. Forward contracts are non-standardized and can be customized according to the requirements of those entering the contract. Therefore, they are also not traded on formal exchanges and are instead traded as an over the counter security. A futures contract acts as an obligation that must be fulfilled by both parties. It either must be met with a physical settlement where the underlying asset will be delivered at the specified price, or a cash settlement can be made for the derivative’s market value at the time of maturity.
For example, a Brazilian farmer of coffee beans can enter into a forward contract with Nestle to 100,000 pounds of coffee beans for $2 per pound on the 1st January 2010. A forward contract can benefit both farmer and Nestle company as it provides the farmer with an assurance that the coffee beans will be purchased at a previously agreed upon price, and will also benefit Nestle as they now know the cost of purchasing coffee in the future that can help them with their planning while also reducing any uncertainty in price fluctuations.
Swap
A swap is a contract made between two parties that agree to swap cash flows on a date set in the future. Investors generally use swaps to change their asset holding positions without having to liquidate the asset. For example, an investor that holds risky stock in a firm can exchange dividends returns for a lower risk constant income flow without selling off the risky stock. There are two common types of swaps; currency swaps and interest rate swaps.
An interest rate swap is a contract between two parties that allows them to exchange interest rate payments. A common interest rate swap is a fixed for floating swap where the interest payments of a loan with a fixed rate are exchange for payments of a loan with a floating rate. A currency swap occurs when two parties exchange cash flows denominated in different currencies.
What is the difference between Forward and Swap?
Forwards and swaps are both types of derivatives that help organizations and individuals to hedge against risks. Hedging against financial loss is important in volatile market places, and forwards and swaps provide the buyer of such instruments the ability to guard against risk of making losses. Another similarity between swaps and forwards is that both are not traded on organized exchanges. The major difference between these two derivatives is that swaps result in a number of payments in the future, whereas the forward contract will result in one future payment.
• Derivatives are special financial instruments that derive their value from one or more underlying assets. Forwards and swaps are both types of derivatives that help organizations and individuals hedge against risks.
• A forward contract is a contract that promises delivery of the underlying asset, at a specified future date of delivery, at an agreed upon price stated in the contract.
• A swap is a contract made between two parties that agree to swap cash flows on a date set in the future.
• The major difference between these two derivatives is that swaps result in a number of payments in the future, whereas the forward contract will result in one future payment.