Beginners Guide to Swaps

You might remember in 2007, during the Financial crisis, the word CDS (Credit Default Swap) was hovering on every news channel. These CDS’s were used to finance mortgages for many people and  so it is important to note, what swaps are and what their uses are?

First we shall define a swap, a swap is when two parties exchange financial instruments (bonds, commodities, etc.), hence the name ‘swap.’ Just like futures, swaps can be used to hedge the market to cover risk and are often used for speculative purposes. In addition,  a business can benefit by cheaper borrowing. There are different types of swaps, commodity swaps, FX swaps, CDS, asset swaps, interest rate swaps, trigger swaps etc. Interest rate swaps make up much of the swap market, and all swaps are traded over the counter (OTC). Over the counter means, that the trade is made between two parties, and is done without the support of an exchange. We will mainly be talking about FX swaps. Swaps are a form of derivative.

In terms of the FX market a swap it is a legal binding contract which one party pays an amount of currency at a particular date and at a fixed date. In this same instance, they resell an identical quantity for a later date and at a fixed rate.

An example:

Let a company be called A, then, if company A needs some financing over 10 years to add more machinery and let company A be based in the UK. The amount needed in total is £10 million, in other words £1 million pounds per annum.  We are going to use the LIBOR (London Interbank Offered Rate) rate of 0.5% and the Chinese rate of 6%. The company also has a plant in China, the company issues 1 million Yuan over a 10 year period at a 6%. Then a financial intermediary, swaps the Yuan into GBP. The financial intermediary pays the company the 1 million Yuan a year whilst the company pays £1 million to the financial intermediary. Both are respect to interest rates and time frame.

There are two types of currency swaps:

1.       Vanilla swaps: These swaps are based floating-floating and fixed-floating architecture.

2.       Circus Swap: the 2 in 1 swap, an interest rate swap mixed with a currency swap. A variable rate loan is swapped with a fixed rate loan. Both loans are in different currencies.

Anatomy of a swap (courtesy of Wall Street Journal)

Exiting a swap, is quite simple and there are numerous ways to exit one. A party may exit the contract and pay the market price for the swap, unhedging costs, broker costs, replacement costs and margins, this is known as buying out the counterparty. A party could also sell the swap to someone else. This needs to be stated in the contract and that both parties should agree. There are other ways to exit a swap, but they are more complex and we shall not indulge in them.

CFDs, spreadbetting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary.

Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.