Beginning Trading and Understanding Swaps:
Trading beginners may be unfamiliar with the phrase “swap” and its meaning. Worry not—we’ll assist! This beginner’s tutorial will explain swaps and how they function in trading.
What’s swap?
Swaps are financial agreements between two parties to exchange cash flows over time. Cash flows might be interest, currency transactions, or financial assets. Swaps are used to hedge risk or speculate on market circumstances.
Let’s explore swap types:
Interest-rate swaps
The most prevalent swaps are interest rate swaps. Two parties exchange fixed and variable interest rate payments based on a notional principle amount in this swap. The fixed interest rate is set, whereas the fluctuating rate is dependent on LIBOR.
Interest rate swaps often hedge interest rate swings or improve borrowing conditions. Variable-rate borrowers may use an interest rate swap to lock in a fixed rate and eliminate uncertainty.
Currency swaps
Currency swaps trade principal and interest in various currencies. Multinational firms and foreign currency investors employ these swaps. Currency swaps let businesses manage exchange rate risk or acquire finance in other currencies.
A US corporation with European operations may engage into a currency swap to convert euro-denominated payments into US dollars, reducing exchange rate risk.
Swaps of commodities
Commodity swaps exchange cash flows depending on the price of oil, gas, or agricultural goods. Commodity producers and consumers utilize these swaps to hedge price swings.
An airline may arrange a commodities exchange to lock in a jet fuel price, minimizing price rises.
The Swap Process
A swap agreement’s terms are written in a contract between the parties. The contract defines the swap term, notional principal, cash flow payment dates, and other characteristics.
OTC swaps are privately arranged between two parties rather than traded on an exchange. This increases customisation freedom but increases counterparty risk.
As interest rates and commodity prices vary, swap values change. According to the swap arrangement, one party may make periodical payments to the other depending on value changes.
Conclusion
Swaps help traders control risk and capitalize on market opportunities. We’ve explained interest rate, currency, and commodity swaps in our beginner’s tutorial.
We suggest reading the following sources to learn more:
Sources and References:
Investopedia – https://www.investopedia.com/terms/s/swap.asp
Wikipedia – https://en.wikipedia.org/wiki/Swap_(finance)
Financial Times – https://www.ft.com/content/5dfae3bc-6554-11e9-a79d-04f350474d62