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Swap: what it is and what it is used for
We know that acquiring the necessary knowledge to move confidently in the financial market is a process that takes time and dedication. That is why we have created this space to help you become familiar with the most important concepts, which will give you a clear vision not only of what is happening in our local economy, but also at a global level.
There are aspects of the financial world that may seem foreign or complicated at first glance, but have a direct impact on our daily lives, often without us realizing it. A good example of this is the concept of “swap”, which you may remember from its appearance in the acclaimed movie The Big Bet, although if you are not familiar with the term, you may need more context to fully understand it.
Keep reading this article which will be of great help to you in understanding this term.
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What is a Swap?
“Swap is a term that refers to an agreement between two parties to exchange assets or obligations for a specified period of time. This exchange can involve different types of financial assets, such as interest rates, currencies, commodities or other financial instruments.
There are several forms of swaps, the most common of which are:
- Interest rate swaps: in this type of swap, the parties agree to exchange interest payment streams, often from a fixed rate to a floating rate or vice versa. This can be done to manage interest rate risk or to seek more advantageous financing opportunities.
- Currency swaps: In these swaps, the parties agree to exchange fixed amounts of different currencies for an agreed period of time. They are often used to hedge against exchange rate risks or to access financing in different currencies.
- Commodity swaps: These swaps involve the exchange of cash flows based on the price of a particular commodity. They can be used to manage commodity price risk.
- Total return swaps: In this type of swap, one party agrees to pay the other party for the change in the price of an asset, as well as any income stream generated by the asset. It is often used to gain exposure to an asset without the need to own the underlying asset.
What are the advantages of the Swap?
There are several advantages of the Swap that we want to show:
- Protection against exchange rate fluctuations.
- Possibility of financial gains
- Substitution of fixed-rate yields for post-fixed rate yields
What are the disadvantages of the swap?
There are also several disadvantages of the swap, including
- Transaction cost, especially in taxes
- Risk of doing it on unregulated platforms.
How is a swap calculated in trading?
The calculation of swaps in trading varies depending on the type of financial instrument being traded, but in general, the calculation of swaps mainly involves considering the interest rates involved in the transaction.
To understand how swaps are calculated in trading, these steps should be taken into account:
Interest Rate Swaps:
- In the case of Interest Rate Swaps, the calculation of the swap is based on the difference between the interest rates agreed between the parties. The party paying the fixed interest rate will receive the variable interest rate and vice versa.
- The value of the swap is calculated by multiplying the notional principal, the difference between the interest rates and the number of days in the calculation period, and then adjusting it by the exchange rate, if necessary.
Currency swaps:
- For currency swaps, the calculation of the swap usually involves the difference in interest rates between the two currencies involved in the transaction.
- The value of the swap is calculated from the difference between the interest rates of the currencies, the principal amount, the number of days in the period and the applicable exchange rate.
Commodity swaps:
- In Commodity Swaps, the calculation of the swap may be based on changes in the prices of the commodities involved in the transaction.
- The value of the swap will depend on the changes in commodity prices and the terms agreed in the contract.
Total return swaps:
- In the case of Total Return Swaps, the calculation of the swap may involve the total return of an underlying asset, including capital gains, dividends and other forms of income associated with the asset.
How swaps work in foreign exchange trading
In foreign exchange trading, swaps (also known as “rollovers” or “overnight interest”) are used to manage currency exposure overnight, when positions are held open after the market closes. These swaps are essentially interest rates that are paid or received based on the difference between the interest rates of the currencies involved in a currency pair.
Interest rate differential:
- Each currency has its own interest rate, determined by the central banks of their respective countries. When you trade a currency pair in the foreign exchange market, you are basically buying one currency and selling another. If the interest rate of the currency you buy is higher than the interest rate of the currency you sell, you will receive a positive swap. If the opposite is true, you will pay a negative swap.
Daily turnover:
- Currency positions are settled in two business days (T+2). If you keep a position open beyond this timeframe, a rollover will apply, which is the interest you pay or receive for keeping the position open overnight.
Automatic execution:
- Most forex brokers automatically apply swaps to positions held overnight. The amount of the swap is usually displayed on the broker's trading platform.
Impact on trading:
- Swaps can affect the bottom line of a trade, especially if the position is held for a long period of time. Traders should be aware of swaps when planning their trading strategies.
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Why does the Central Bank hold swap auctions?
A country's Central Bank holds swap auctions as part of its exchange control strategy. These contracts allow the Central Bank to access foreign exchange, reducing the entry of investors into the spot market. This action helps to control sharp changes in the exchange rate, minimizing the impact on inflation.
Swap auctions are key instruments used by Central Banks for a number of reasons including
- Stabilization of the domestic currency against other foreign currencies.
- Controlling inflation by avoiding excessive exchange rate variations.
- Providing liquidity to the foreign exchange market in times of instability.
- Protection against external shocks that may affect the domestic currency.
- Support foreign trade by keeping the currency at competitive levels.
Conclusion
As we have already explained, to make profits in trading, you need to buy the currency with a high interest rate and sell the currency with a low interest rate. In a pair like BTC/USD, this implies a short position in the pair.
This premise will guide the trading strategy to be followed, since in this case the trader must wait until the pair is in a downtrend before opening his selling positions. To do so, he will take advantage of any change to enter a short position and hold that position while the downward movement continues.
