Understanding Swaps

The basic meaning of swap is exchanging something for another.

In finance, a swap is a contract between two parties where they exchange cash flows of two different financial instruments over a specified period. One cash flow is fixed while the other cash flow can change based on factors such as interest rates, commodity prices among others. Interest rates, currencies, and commodities are some examples of financial instruments that are exchanged.

Swaps are traded over the counter. Over the counter is where trading of financial instruments is done directly between two entities without the involvement of a central exchange. Some participants in the swap market are financial institutions and companies.

Reasons for Using Swaps

To mitigate risks. Swaps are used to minimise risks. For example, commodity swaps mitigate the risk of changes in commodity prices while currency swaps protect against risk in case of fluctuations in the currency exchange rates.

Exposure to new markets. Since swaps are traded over the counter, a company may gain access to new markets, and parties outside the central exchange willing to trade swaps with them. Consequently, this may lead to the company gaining financial benefits.

Types of Swaps

Different swaps serve different purposes. Some of them include;

Currency Swaps

Also known as FX swaps, these swaps are traded when the financial flows of two different currencies are exchanged by the parties involved. The purpose of this swap is to hedge against potential loss associated with changes in currency exchange rates.

Currency swaps are used by companies with operations in different countries.

The types of currency swaps include;

Fixed for fixed swap – This is exchanging fixed interest payments in one currency for fixed interest payments in a different currency.

Fixed for float swap – This is exchanging fixed interest payments in one currency for floating interest payments in another currency.

Commodity Swaps

These are contracts where the parties involved exchange the floating cash flows for the fixed cash flows (that are dependent on the commodity price) with one another. Commodity swaps enable a company to control the risks associated with changes in the commodity price. Examples of commodities are crude oil, gold, and silver.

Interest Rate Swaps

A fixed interest rate is a rate on a financial instrument that does not change during the period of the contract. The floating interest rate on the other hand changes during the period.

Islamic Swap

The Islamic swap is also known as a swap-free.

The Islamic swap is one where receiving or paying interest on a financial instrument is prohibited. This is because according to Islamic law, Muslims are forbidden from receiving or paying interest in their transactions. For example;

In Islamic Forex accounts, when you open a trading position and keep it open overnight, you will not be subject to rollover fees. A rollover fee is an interest payment made when a trader holds a position overnight to the next trading day.

Swaps in Forex Trading

A swap in Forex trading is an overnight interest that you either pay or receive for a trade that you hold open overnight.

Swaps apply only when a position is held until the following trading day. Swaps do not apply when a trade is opened and closed within a day.

There are two types of Forex trading swaps and they are long swaps and short swaps.

  • Long swaps. This is where a trader opens a buy position and leaves it open overnight.
  • Short swaps. This is where a trader opens a sell position and keeps it open overnight.

The difference in interest rates between the 2 currencies in the currency pair and the position taken whether to buy or sell determines whether the trader will pay or earn the interest fee.

Trader paying the interest fee

If the interest rate of the currency you’re buying is lower than the interest rate of the currency you’re selling, then you will pay the fee. For example;

A trader enters a long position on GBP/USD. If the interest rate of GBP is lower than that of USD, the trader will be charged the interest fee for holding the position overnight.

Trader earning the interest fee

When the interest rate of the currency bought is higher than that of the currency sold, the trader has a chance to earn the interest fee. For example;

A buy position on EUR/JPY is opened. If the interest rate of EUR is higher than that of JPY, the trader will potentially receive the interest. 

Factors Influencing the Swap Rate

The amount of interest that a trader can earn or pay is influenced by the factors listed below;

  • The trading positions entered: either buy or sell position.
  • The interest rate differences of the financial instruments involved.
  • How long (days) the trading position has been kept open.
  • The commission rates charged by brokers.

How to Calculate the Swap Rate

Short position

Swap rate=(contract * [interest rate difference + commission] /100) * (price / number of days in a year)

For example; A trader sells 1 lot of GBP/USD trading at 1.2400. Let’s assume the GBP interest rate is 4% and for USD is 2.5%. The interest rate difference is 1.5 and the broker’s commission is 0.25%. The commission is added in the formula since the interest rate of the currency sold (GBP) is higher than the one of the currency bought (USD). 

Swap rate=(100000 * [1.5 + 0.25] /100) * (1.2400 / 365)= USD 5.95

When this trade is kept open overnight to the next trading day, the trader will be charged USD 5.95 from his/her account.

Long position

Let us use the previous example as a buy position. A trader buys 1 lot GBP/USD at 1.2400. GBP=4% and USD=2.5%. This time, the commission will be subtracted from the formula since the interest rate of the currency sold (USD) is lower than that of the currency bought (GBP).

Swap rate=(contract * [interest rate difference – commission] /100) * (price / number of days in a year)

=(100000 * [1.5 – 0.25] /100) * (1.2400 / 365)= USD 4.25

Here, if the trade is kept open to the next trading day, the trader will earn the USD 4.25 interest into his/her account.

Conclusion

When applied effectively, swaps serve as an important strategy for companies to manage their risks and obtain financial benefits from their transactions.

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