Credit default swaps and interest rate swaps are fiscal derivatives. A fiscal derivative is an agreement among two or additional parties wherein they give their consent to give each other a definite sum of money as per the worth of an asset, which could be a bond, stock or some other security. The amount of cash to be paid and which of the parties would pay is decided by how the worth of the asset varies with time.
Interest Rate Swaps
The simplest kind of interest rate swap comprises of an agreement between two parties, with one party agreeing to make regular payments to the other party. These payments are derived from payment of interest collected form an asset capable of generating interest. A bond would be an example of such an asset. The date for making payment is usually the same as the date of receiving interest on payment. Since the rate of interest on assets keeps fluctuating all the time, one of the parties may have to make more payment than the other or it could be the other way round.
Credit Default Swaps
In case of a credit default swap, one of the parties concurs to give a series of projected payments in cash to the other party. As barter, the other party concurs to give the first party a definite quantity of money in case the worth of an elected asset, like a bond, capable of giving interest, has had a steep fall. For instance, if there is a default by the bond issuing authority, a person who bought a credit default swap, connected to that particular bond, will be entitled to get paid from the party that sold him the swap.
The idea at the back of designing credit default swaps and interest swaps is to provide some protection against the fluctuations that the value of the asset may face. These are comparable to insurance. In case of an interest rate swap, the lender or the borrower is seeking hedge against an unexpected change in the rate of interest, which might amount to his losing a lot of money. In case of a credit default swap, the buyer of the swap is buying compensation, should the issuer of the asset (which he already possesses) capable of generating interest fail to pay.
Usually, interest rate swaps are attached to the changes in the two rates of interest. As per the changes occurring in the rates of interest, it may become necessary for one party to make payment to the other party. At the same time, as a result of the changed rate of interest, it would become essential for the second party to make payment to the first party. On the other hand, credit default swaps are usually attached to the worth of one asset only.