SWAP (swap transaction is also called rolover and overnight) – this is an operation to leave open positions for the next day for which we get or pay interest. The first swap transaction was an exchange of USD (US Dollar) on the CHF (Swiss franc), held in August 1981 between the American corporation IBM and the International Bank for Reconstruction and Development.
Swap contracts are used inter alia in the case of wanting to limit foreign exchange risk or interest rates.
Basic types of swap transactions
The first swap transaction was the exchange of USD (US $) on CHF (Swiss franc) and was held in August 1981 between IBM and the International Bank for Reconstruction and Development.
The swap currency market is divided into several types and each has its own specifications:
- Currency swap (FX swap)
- Interest rate swap (IRS)
- Cross currency interest rate swap (CIRS).
Two terms like spot and forward are used to determine the type of currency contract.
Essential concepts for SWAP contracts
Spot – the operation of the physical delivery of the currency.
- Forward – A currency swap after a previously agreed rate, whereby the exchange rate will be applied in the future in the contract.
- Standard Swap – occurs when the settlement date is closer to the spot, and the next is on a forward basis (paid under pre-established conditions).
- Short swap (one day) – occurs when transactions are made up to the spot date.
- Forward Swap – occurs when the first part of a transaction is settled on the exchange rate conditions we agreed to trade today for the purpose of ensuring the exchange of currency at a future forward rate, and for the last part of a spot transaction.
In our case, we assume that we are not interested in the physical delivery of the currency, so our open positions will not reach the settlement date and will be adjusted daily for swap points.
Why do investors use SWAPs? Examples
Motivation for using SWAP contracts is either a commercial need or a desire to gain market advantage. Some business activities of financial firms lead to exposure to currency risk and interest rates that SWAPs mitigate. As an example, you can provide a commercial bank that pays variable rate on deposits and receives a fixed return on loans. This mismatch between assets and liabilities often causes difficulties. Thus, SWAPs can be used here to pay a fixed rate and receive a variable rate of return in exchange for converting fixed assets to variable rate assets.
In the case of companies also can be explained on a simple example. Let’s say a popular company in the US wants to expand its business in Europe, but it’s far less known. So it will receive much more favorable financing conditions in the United States and then using currency SWAP will convert funds into euros needed to fund expansion in new markets.
On the FX / CFD market, swap points are fees for “overnight transactions”, that is, keeping them overnight and resulting from a difference in interest rates for the currency pair or storage costs. As a result, foreign exchange SWAP can be positive (the trader earns it) or negative (the trader loses it). Tracking swap points and investing in positive swaps can be an additional return for an investor.
In what situations do we earn on swap points?
We know that each country has its own interest rate. We earn when we buy a currency in a country with a higher interest rate against a currency in a country with a lower interest rate. In practice, the FOREX market looks like taking a loan in one country (which has a lower interest rate) and depositing money in another country (which has a higher interest rate).
How does a currency swap work?
If we have a large difference between interest rates in countries and we buy the currency of the country with a higher interest rate relative to the currency of the country with the lower, and hold the position open overnight, then we earn not only on price movements but also on swap points.
It may sound complicated, but on the FOREX market through brokers we can do such a transaction with a click of a mouse – Broker List. Simple, right?
We make a transaction where we buy Rubles (EUR) on the FOREX market. In fact, we buy (and put on deposit) rubles with a higher interest rate and we give the euro (which was taken in credit for the purchase of rubles when opening positions), which have a lower interest rate.