HFM information and reviews
HFM
96%
FXCC information and reviews
FXCC
92%
FxPro information and reviews
FxPro
89%
FBS information and reviews
FBS
88%
Vantage information and reviews
Vantage
85%
XM information and reviews
XM
82%

What Are Swaps In Trading, And What Are They Used For?


Swaps help all market participants to enter into contracts that will be profitable in a particular situation. They reduce the risk of market transactions and can increase potential profits. Apart from that investors use different types of swaps to hedge risks and increase trading efficiency in the stock market. What they are and how they work - in the article.

What Is A Swap?

A swap is a derivative contract concluded between bidders. In a swap, the parties exchange various assets with each other and agree to return them to each other after a certain period. Most frequently market participants use swaps to buy and sell securities, and commodities or carry out foreign exchange transactions. Unlike futures and options, swaps are not concluded on stock exchanges but in the over-the-counter market.

Typically, it is not individual investors who use swaps, but companies, investment funds, or large financial institutions, such as commercial banks. They set certain terms and conditions between themselves and enter into a contract to reduce potential risks and increase profits. Many brokers do not allow their clients to use swaps because such transactions require special knowledge and expertise.

Why Use Swaps?

There are two main reasons traders use swap trades: To reduce risk. Many market participants use swap transactions to hedge profits and avoid additional costs. For example, interest rate swaps help hedge interest rate fluctuations. Currency swaps allow investors and traders to avoid worrying about which way currencies will go. Commodity swaps fix the prices of certain exchange-traded commodities, meaning price changes do not affect the transaction. Access new markets. To enter a market in another country, companies can use borrowed funds. However, interest rates for foreign companies are usually higher than for local players. To avoid overpaying and lower interest rates, companies use a currency swap.

Stock Swap

Stock swaps are instruments in which the parties to an agreement exchange the yield on securities for interest income. Suppose an investor wants to invest in a foreign company, but cannot do so themself because of certain restrictions. So they make a swap deal with an investment bank and ask it to buy shares of that company. In return, the investor will pay the bank the rate of return on those shares that the parties set in the contract, such as 7%.

Stock swaps can be used by companies during mergers and acquisitions. In this case, the parties to the transaction value the shares of both companies to set a fair swap ratio between them.

For example, in 2017, the chemical companies Dow Chemical Company (Dow) and E.I. du Pont de Nemours & Company (DuPont) completed a merger to form Dow DuPont. The exchange ratio for Dow stockholders was 1.00 shares of Dow DuPont stock for each share of Dow stock. The exchange ratio for DuPont shareholders was 1.282 shares of Dow DuPont for each share of DuPont.

Interest Rate Swap

An interest rate swap is a derivative financial instrument used by bidders to hedge interest rate risk or to speculate. One party to the transaction pays the other party a fixed percentage of the amount set out in the contract. The other party pays the first floating interest. The parties also agree on the frequency and duration of the exchange. Typically, interest rate swaps are used by banks or legal entities that enter into contracts with banks.

For interest rate swaps, the parties often use LIBOR or the London Interbank Offered Rate. This is the London Interbank Offered Rate or average interest rate used around the world to calculate loans and various debt instruments.

Let's imagine that ABC has just issued a five-year $1,000,000 bond with a variable annual interest rate. The rate is equal to LIBOR + 1.3%, or 130 basis points. Suppose LIBOR is at - 2.5%, and ABC's management is worried that the interest rate might rise. Therefore, the management of ABC finds another company, XYZ, which is willing to pay ABC an annual rate of LIBOR + 1.3% of $1,000,000 for five years. That is, XYZ will finance ABC's interest payments on the latest bond issue. For this, ABC will pay a fixed annual rate of 5% of the $1,000,000 over five years to XYZ. ABC benefits from the swap if rates rise over five years. The XYZ benefits if rates fall or do not change.

Currency Swap

A currency swap is an agreement in which two parties exchange principal and interest in one currency for principal and interest in the other. At the beginning of the swap, payments are exchanged at a fixed interest rate. During the term of the swap, each party pays interest on the exchanged principal amount of the loan. At the end of the swap, the principal amounts are exchanged back, either at the current interest rate or at the rate the parties set in the contract.

Let's look at an example.  [Currency-Swap]  For example, a U.S. company may get a loan in the U.S. at a rate of -6%, but it needs a loan in rand to invest in South Africa. The loan rate in South Africa is - 9%. At the same time, the South African company wants to enter the U.S. market, where the interest rate is - 11%. At the same time, in South Africa, the company can use the rate of - 8%.

That is, each side of the currency swap reduces costs because the other side uses the rate of a certain country. That is, a U.S. company will borrow dollars at 6 percent, and then lend the funds to a South African company at the same rate. A South African company can borrow the South African rand at 8% and then lend the funds to an American company.

Commodity Swap

A commodity swap is a type of derivative contract in which the parties to a transaction exchange payments based on the price of a particular commodity. A swap allows producers and consumers to fix the price of a particular commodity. The parties to the transaction can then disregard price changes. Therefore, companies use commodity swaps to reduce risks from price fluctuations in commodity markets.

Most often a commodity swap is used to sell and buy fuel, precious metals, or grain. For example, an airline has a contract to deliver 100,000 gallons of fuel. The cost per gallon was fixed by the parties to the deal at $5. Suppose during the contract period, the cost per gallon increased to $5.5.

In this case, the difference between the market price and the contract price would be: 5.5 ー 5 = $0.5. And the other side of the deal will pay the airline: $100,000 * 0.5 = $50,000. That is, with a commodity swap, the airline saves that money. Conversely, if the price of fuel decreased, the airline would pay a certain amount.

Credit Default Swap

Credit swaps are financial instrument that provides insurance against default on a debt instrument. The buyer of the swap remits premium payments to the seller. In exchange, the seller of the swap agrees to repay the loan that the buyer has issued to a third party if it defaults - that is, fails to pay itself. Credit default swaps were a major factor in the 2008 financial crisis.

This type of swap is often used to hedge risk. Banks can hedge against borrower defaults. In this case, they buy a credit default swap. If the borrower can't meet obligations and repay the bank a certain amount of money - the income from the credit swap covers the borrower's debts. A credit swap is especially beneficial when a large percentage of the bank's total loans are to a single borrower.

#source


RELATED

What is a Good Profit Margin in Trading?

Profit margin measures the earnings relative to the revenue. The three main margin metrics are gross profit margin, operating profit margin, and net profit margin...

Bitcoin: secrets of profitable trading

Bitcoin: although this currency is virtual, many people earn and have already earned real millions of dollars thanks to it. More than 1,000 people...

What is spread in Forex?

Spread is one of the main conditions for trading and investing in Forex. You should know what Forex spread is if you want to trade in the foreign exchange market...

3 Not-so-hot Tips for New Traders From

A new wave of investors, or collectively known as “Generation Investors”, has spurred into the stock market during the pandemic. Research conducted by the FINRA Investor...

Trading on Forex - A Primary Source of Income

There are a lot of discussions about trading within the boundlessness of the Internet, both in conventional businesses and state-financed organizations...

The Basics of Forex Trading

Forex trading has been around since the 1970s but with the advancement of technology, and the advent of online trading platforms across the years, its popularity has been growing exponentially...

The core concept of money management

Risk management, also known as money management, refers to a number of trading techniques employed to lessen risk exposure. Being affected by various factors...

A Guide to Cryptocurrency trading

If you've decided to invest in the cryptocurrency market, as with all investments, it's important to do your research. Although Bitcoin is the most well-known...

How to Choose the Best Forex Broker

Choosing the best forex broker to open a trading account is quite hard as there are numerous choices available online. Although competition is very high pushing brokers...

Fundamental Analysis: A Beginner's Guide

Different methods are employed by investors and traders to anticipate the fluctuations in the prices of stocks, currencies, and other financial instruments...

Most Important Forex Regulators in the World Today

It is important to regulate forex because the amount of money which passes through the market everyday makes it very attractive for all sorts of scammers...

Technical and Fundamental analysis

Technical analysis complements fundamental analysis by focusing more on numbers, patterns, and statistics, instead of the intrinsic value of an asset...

Are you looking for a new hobby? Put Your Skills to Better Use

Are you looking for a new hobby, but aren't quite sure where to start? Have you considered you might be a trader? Below are a series of questions that will help...

Reading Forex Charts: Decoding Patterns, Indicators, and Informed Decisions

In the world of forex trading, understanding price movements is paramount. Forex charts serve as the canvas upon which traders analyze historical and current price data to make informed decisions...

Best Day Trading Laptops in 2023

When discussing the requirements for successful trading, pro traders often mention having the right tools. A quality laptop is among such tools. A trader needs a good laptop just as much...

How to control your emotions while trading

Controlling one’s emotions while trading requires practice and mindfulness which means forex trading psychology. This presents a unique challenge for all traders when...

The Bitcoin's smarter brother: an Octa's guide to Ethereum

What makes this digital asset so unique, and what drove its robust growth over the recent years? In this article, the experts at Octa, a financial broker with globally recognised licences, give a rundown of the ETH's impressive ascent in the world of cryptocurrencies.

What is forex and how does it work?

Throughout history, we have seen the transition of trading from one form to another. From the exchange of one material to another and this hasn't stopped for a moment...

What Is A Demo Account And Why Is It So Important?

A trader gradually learns the essence of exchange trading. In this case, he can choose two ways - to use a demo account or trade immediately for real money...

Stock Indices: What Are They And How To Trade Them

When describing the markets, we might hear of popular phrases like “the market has surged higher” or “stocks tumbled to new lows” when reading and listening to news reports...

FP Markets information and reviews
FP Markets
81%
IronFX information and reviews
IronFX
77%
T4Trade information and reviews
T4Trade
76%
Exness information and reviews
Exness
76%
Just2Trade information and reviews
Just2Trade
76%
FXNovus information and reviews
FXNovus
75%

© 2006-2025 Forex-Ratings.com

The usage of this website constitutes acceptance of the following legal information.
Any contracts of financial instruments offered to conclude bear high risks and may result in the full loss of the deposited funds. Prior to making transactions one should get acquainted with the risks to which they relate. All the information featured on the website (reviews, brokers' news, comments, analysis, quotes, forecasts or other information materials provided by Forex Ratings, as well as information provided by the partners), including graphical information about the forex companies, brokers and dealing desks, is intended solely for informational purposes, is not a means of advertising them, and doesn't imply direct instructions for investing. Forex Ratings shall not be liable for any loss, including unlimited loss of funds, which may arise directly or indirectly from the usage of this information. The editorial staff of the website does not bear any responsibility whatsoever for the content of the comments or reviews made by the site users about the forex companies. The entire responsibility for the contents rests with the commentators. Reprint of the materials is available only with the permission of the editorial staff.
We use cookies to improve your experience and to make your stay with us more comfortable. By using Forex-Ratings.com website you agree to the cookies policy.