Bond swap

Not every position adjustment in a bond portfolio needs a derivative. Sometimes the simplest tool is to just sell what you hold and buy something else with the money.

The workbook's own words, drawn straight from its comparison of interest rate instruments: "A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Theoretically, it is two underlying bond transaction rather than derivatives contract."

The workbook places bond swap in a comparison table alongside three genuine derivative instruments, precisely to draw out this contrast:

The defining feature is that nothing new is created. A bond swap does not involve a notional amount, an exercise right, or a separate contract layered on top of an underlying asset — it is simply two ordinary cash bond trades (a sale and a purchase) executed together as one investment decision. That is exactly why the workbook flags it as "theoretically... two underlying bond transaction rather than derivatives contract" — it sits in a table of derivative instruments only because it serves a similar portfolio-management purpose, not because it shares their legal structure.

An investor holds Rs 50 lakh face value of a 10-year government bond carrying a 6% coupon, currently priced at Rs 98 per Rs 100 face value.

The investor's view changes: they now expect interest rates to fall further out on the curve, and prefer to hold a longer-tenor bond to capture more price appreciation.

Step 1 — sell. The investor sells the Rs 50 lakh face value 10-year bond at Rs 98, realising Rs 49,00,000 in sale proceeds.

Step 2 — buy. The investor simultaneously uses that Rs 49,00,000 to buy a longer-tenor 15-year government bond at its prevailing price.

That is the entire bond swap: two ordinary bond transactions — a sale and a purchase — executed together, with no derivative contract, no notional principal and no option premium involved anywhere in the structure. The investor has repositioned their portfolio's duration using nothing more than the cash bond market.

Chapter 2 (Interest Rate Derivatives), in the comparison table that walks through forward, swap and option structures for interest rate instruments, places the bond swap alongside them specifically to test whether a candidate can tell a derivative from something that merely looks like one. Expect a question asking which of a list of instruments is not a derivative contract — the bond swap is the answer, precisely because it is "two underlying bond transactions".

• A bond swap is not a derivative, even though the workbook discusses it in the same table as forwards, swaps and options on interest rates — this is the entire point of including it there.
• "Simultaneously" matters. The sale and purchase are executed together as one investment decision, not as two unrelated trades separated in time.
• Do not confuse "bond swap" with "interest rate swap." An interest rate swap exchanges a stream of interest payments on a notional principal amount and is a genuine derivative; a bond swap exchanges one bond holding for another using real sale proceeds.
• No notional amount, no premium, no exercise right — a bond swap has none of the structural features that make the other three instruments in the workbook's table derivatives.
• The workbook hedges its own claim with "theoretically" — signalling that in substance it behaves like a portfolio repositioning tool even though it is legally just two bond trades.