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. 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.

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