Question

Explain how swaps are similar to but different from forward contracts.

Answer 1

Swap is a derivative contract between two parties to exchange cash flows or liabilities with two different financial instruments for a certain time. The common swap derivatives are interest rate swaps. Currency swaps are also prevalent in the market. A forward contract is customized contract between two parties to buy or sell underlying asset at a predetermined price on a specific date. Both, swaps and forward contracts are used for hedging to protect against adverse market fluctuations. However, the key difference between the two is that Swap contract results in a series of payments in the future and forward contracts lead to only a single payment in future. Thus, forward contract is for delivery of underlying asset while swap is to swap cash flows at a future date.