What is a swap and what is it used for?
What is a swap and what is it used for?
Thinking of those who want to better understand the intricacies of the derivatives market, we have prepared a guide with fundamental concepts about swaps. In it, you'll learn how this type of transaction works, what it's used for, the most common types of swaps, and even how they're used by the federal government to adjust the country's currency exchange rate.
What a swap is?
A swap is a type of derivative financial instrument. It represents an agreement between two parties - companies, investors, or a company and an investor, among other options - to exchange cash flows based on an underlying value, term, and other predetermined terms and criteria. The value of a swap contract is increased or decreased in accordance with these rules and parameters. Swaps are also often defined as an exchange of "risk" in which participants trade the returns of two different assets or commodities.
They are commonly used in hedging strategies that can last for long periods of time. Companies often use swaps because their operations are exposed to different types of risks. For example, importing and exporting companies face exchange rate fluctuations, airlines are affected by changes in fuel prices, and fund managers face stock market volatility. All of these situations require effective instruments to minimise risk and ensure stability. But how does a swap work in practice? This will be easier to understand with an example of what is considered to be the predecessor contract of this market.
Example of use
In the early 1980s, IBM and the World Bank signed a currency swap agreement. According to the agreement, the bank was to take over IBM's debts in Swiss francs and German marks (the country's currency at the time). IBM, in turn, would assume the financial institution's dollar debts. The World Bank needed to raise funds in Swiss francs for projects, but the market had very high interest rates. IBM, on the one hand, had a large presence in the Swiss market and could get loans at favourable rates. On the other hand, IBM needed dollars for important projects, a currency to which the World Bank had access on good terms.
If the needs of the two companies were different, but complementary to a certain extent, why not make an exchange - or swap? That's what they did. IBM applied for loans in Swiss francs and the World Bank in dollars. In the transaction, they exchanged principal and interest payments. As a result, IBM was able to pay a lower interest rate than if it had to raise money on the market. The same thing happened with the World Bank. Both organisations benefited from their advantageous position in different markets. Since then, this market has evolved and today encompasses a variety of other transactions and assets, the most common being swaps on interest rates, currencies and commodities.
To better understand how swaps work today, imagine a gold swap against the Ibovespa index. In this example, one party to the agreement pays the other party swings in gold and in return receives swings in Ibovespa. The other party does the opposite: they pay fluctuations in Ibovespa and receive fluctuations in gold. What happens if gold rises less and Ibovespa rises more? The party that bought the Ibovespa index (and sold gold) will get the difference. If the opposite happens and gold rises more than Ibovespa, the party that bought gold and sold Ibovespa will get the difference.
Swaps and hedging
Swap transactions are widely used by companies and investors for hedging purposes. However, they are just one way of protecting a portfolio, position or business. They are not quite as synonymous as they may seem. Different compositions of assets and derivatives can be put together for hedging purposes that utilise different alternatives to swaps. Classic strategies involve the use of futures contracts and paper options, which were originally created for this purpose. Their existence dates back centuries, while swaps are considered a much more recent financial invention.
Types of swaps
There are several types of swaps that are commonly traded in the market. They differ depending on the assets or commodities involved in the in-line exchange contracts, which serve as a sort of index for the transaction. One of the best known is the currency swap. In a currency swap, parties exchange principal and interest in one currency for principal and interest in a second currency. It is agreed that one party will make payments in one currency and the other in another currency, for future dates.
Index swaps involve the exchange of cash flows linked to the return or performance of price indices such as IPCA or IGP-M, or stock indices such as Ibovespa, IBrX-100 or others calculated by B3. These instruments allow market participants to capture index-specific returns and manage their investments more efficiently. For example, the Ibovespa swap on the DI rate, one of the main measures of fixed income returns, involves exchanging a cash flow indexed to the Ibovespa yield (usually plus the interest rate) for another flow linked to the change in DI.
In the case of interest rate swaps, the parties exchange indices linked to their assets or liabilities and one of the variables is the interest rate. An example of this type of negotiation is a swap of the DI rate against the dollar. In this case, the parties exchange cash flows indexed to DI for other flows indexed to the change in the exchange rate plus an interest rate agreed between them. Another possibility is a DI to fixed rate swap, which follows the same logic but with different indexes.
Swap contracts
Swaps are mostly traded on the OTC market and are not standardised. As such, there is no possibility of transferring a position to another investor or company. As a result, anyone who enters into a swap is obliged to fulfil the contract before maturity. Swaps have a similar characteristic to forward contracts, which differs from derivative instruments such as futures contracts: there are no payments of funds - the so-called "daily adjustments" that are present in the futures market - during the life of the agreement. The transactions are settled financially, at the time of maturity of the contract for the difference between the flows exchanged by the investors.
<h2>Central ank currency swaps</h2>
From time to time, those who follow economic news hear that the Central Bank has conducted currency swap transactions. So why would the Central Bank enter this market by conducting these types of transactions? Currency swaps are one of the tools that the Central Bank uses to control the exchange rate - in other words, the value of our currency against the dollar. Dirty fluctuations are used here because, although the government does not set the exchange rate, it takes certain actions to set its direction. This is because a very high or very low exchange rate over a short period of time will have a significant impact on the economy.
The operators of currency swaps are the Central Bank, financial institutions and companies with dollar debts. While the Central Bank uses these operations to maintain stability, companies and financial institutions use them to protect against currency fluctuations. In practice, currency swaps stipulate that the Central Bank pays for exchange rate fluctuations for the duration of the contract and the other parties (companies) pay an interest rate, which is usually the DI or Selic rate. Thus, whoever buys a currency swap becomes active with respect to interest rates and passive with respect to exchange rates, but the opposite is true for those who sell.
Currency swap contracts are concluded at auctions organised by the Central Bank, often without prior notice. It is at these that the terms of the contracts are finalised. The monetary authorities authorise financial institutions - so-called dealers - to conduct transactions on this market.
Traditional and reverse swaps
The main difference between a traditional currency swap and a reverse currency swap is that in the case of a traditional swap, the central bank pays for the change in the exchange rate and receives the interest rate (either DI or Selic). In practice, this transaction shows that the authority expects the exchange rate to fall - so it is often said to be equivalent to selling dollars in the futures market. At the opposite end of the spectrum are those who believe that the exchange rate is likely to rise. In reverse currency swap transactions, the opposite is true. The central bank offers an interest rate and the other side makes money on the change in the exchange rate over a given period. This method is used when the exchange rate falls sharply.
Conclusion
Swaps play an important role in the financial markets, providing companies and investors with a useful tool for risk management and stability. As financial markets evolve and new technologies emerge, swaps will continue to play a key role in ensuring the efficient functioning of the global economy.
Ольга Ларина
07-12-2024, 10:27 AM #1One of the stars of the derivatives (derivatives) market is the swap. Its name often scares newcomers to trading, but for those who regularly follow financial news, swaps are not new. From time to time companies may enter into a swap or an investor may ask how to set up a swap transaction, but what exactly are swaps?
Thinking of those who want to better understand the intricacies of the derivatives market, we have prepared a guide with fundamental concepts about swaps. In it, you'll learn how this type of transaction works, what it's used for, the most common types of swaps, and even how they're used by the federal government to adjust the country's currency exchange rate.
What a swap is?
A swap is a type of derivative financial instrument. It represents an agreement between two parties - companies, investors, or a company and an investor, among other options - to exchange cash flows based on an underlying value, term, and other predetermined terms and criteria. The value of a swap contract is increased or decreased in accordance with these rules and parameters. Swaps are also often defined as an exchange of "risk" in which participants trade the returns of two different assets or commodities.
They are commonly used in hedging strategies that can last for long periods of time. Companies often use swaps because their operations are exposed to different types of risks. For example, importing and exporting companies face exchange rate fluctuations, airlines are affected by changes in fuel prices, and fund managers face stock market volatility. All of these situations require effective instruments to minimise risk and ensure stability. But how does a swap work in practice? This will be easier to understand with an example of what is considered to be the predecessor contract of this market.
Example of use
In the early 1980s, IBM and the World Bank signed a currency swap agreement. According to the agreement, the bank was to take over IBM's debts in Swiss francs and German marks (the country's currency at the time). IBM, in turn, would assume the financial institution's dollar debts. The World Bank needed to raise funds in Swiss francs for projects, but the market had very high interest rates. IBM, on the one hand, had a large presence in the Swiss market and could get loans at favourable rates. On the other hand, IBM needed dollars for important projects, a currency to which the World Bank had access on good terms.
If the needs of the two companies were different, but complementary to a certain extent, why not make an exchange - or swap? That's what they did. IBM applied for loans in Swiss francs and the World Bank in dollars. In the transaction, they exchanged principal and interest payments. As a result, IBM was able to pay a lower interest rate than if it had to raise money on the market. The same thing happened with the World Bank. Both organisations benefited from their advantageous position in different markets. Since then, this market has evolved and today encompasses a variety of other transactions and assets, the most common being swaps on interest rates, currencies and commodities.
To better understand how swaps work today, imagine a gold swap against the Ibovespa index. In this example, one party to the agreement pays the other party swings in gold and in return receives swings in Ibovespa. The other party does the opposite: they pay fluctuations in Ibovespa and receive fluctuations in gold. What happens if gold rises less and Ibovespa rises more? The party that bought the Ibovespa index (and sold gold) will get the difference. If the opposite happens and gold rises more than Ibovespa, the party that bought gold and sold Ibovespa will get the difference.
Swaps and hedging
Swap transactions are widely used by companies and investors for hedging purposes. However, they are just one way of protecting a portfolio, position or business. They are not quite as synonymous as they may seem. Different compositions of assets and derivatives can be put together for hedging purposes that utilise different alternatives to swaps. Classic strategies involve the use of futures contracts and paper options, which were originally created for this purpose. Their existence dates back centuries, while swaps are considered a much more recent financial invention.
Types of swaps
There are several types of swaps that are commonly traded in the market. They differ depending on the assets or commodities involved in the in-line exchange contracts, which serve as a sort of index for the transaction. One of the best known is the currency swap. In a currency swap, parties exchange principal and interest in one currency for principal and interest in a second currency. It is agreed that one party will make payments in one currency and the other in another currency, for future dates.
Index swaps involve the exchange of cash flows linked to the return or performance of price indices such as IPCA or IGP-M, or stock indices such as Ibovespa, IBrX-100 or others calculated by B3. These instruments allow market participants to capture index-specific returns and manage their investments more efficiently. For example, the Ibovespa swap on the DI rate, one of the main measures of fixed income returns, involves exchanging a cash flow indexed to the Ibovespa yield (usually plus the interest rate) for another flow linked to the change in DI.
In the case of interest rate swaps, the parties exchange indices linked to their assets or liabilities and one of the variables is the interest rate. An example of this type of negotiation is a swap of the DI rate against the dollar. In this case, the parties exchange cash flows indexed to DI for other flows indexed to the change in the exchange rate plus an interest rate agreed between them. Another possibility is a DI to fixed rate swap, which follows the same logic but with different indexes.
Swap contracts
Swaps are mostly traded on the OTC market and are not standardised. As such, there is no possibility of transferring a position to another investor or company. As a result, anyone who enters into a swap is obliged to fulfil the contract before maturity. Swaps have a similar characteristic to forward contracts, which differs from derivative instruments such as futures contracts: there are no payments of funds - the so-called "daily adjustments" that are present in the futures market - during the life of the agreement. The transactions are settled financially, at the time of maturity of the contract for the difference between the flows exchanged by the investors.
<h2>Central ank currency swaps</h2>
From time to time, those who follow economic news hear that the Central Bank has conducted currency swap transactions. So why would the Central Bank enter this market by conducting these types of transactions? Currency swaps are one of the tools that the Central Bank uses to control the exchange rate - in other words, the value of our currency against the dollar. Dirty fluctuations are used here because, although the government does not set the exchange rate, it takes certain actions to set its direction. This is because a very high or very low exchange rate over a short period of time will have a significant impact on the economy.
The operators of currency swaps are the Central Bank, financial institutions and companies with dollar debts. While the Central Bank uses these operations to maintain stability, companies and financial institutions use them to protect against currency fluctuations. In practice, currency swaps stipulate that the Central Bank pays for exchange rate fluctuations for the duration of the contract and the other parties (companies) pay an interest rate, which is usually the DI or Selic rate. Thus, whoever buys a currency swap becomes active with respect to interest rates and passive with respect to exchange rates, but the opposite is true for those who sell.
Currency swap contracts are concluded at auctions organised by the Central Bank, often without prior notice. It is at these that the terms of the contracts are finalised. The monetary authorities authorise financial institutions - so-called dealers - to conduct transactions on this market.
Traditional and reverse swaps
The main difference between a traditional currency swap and a reverse currency swap is that in the case of a traditional swap, the central bank pays for the change in the exchange rate and receives the interest rate (either DI or Selic). In practice, this transaction shows that the authority expects the exchange rate to fall - so it is often said to be equivalent to selling dollars in the futures market. At the opposite end of the spectrum are those who believe that the exchange rate is likely to rise. In reverse currency swap transactions, the opposite is true. The central bank offers an interest rate and the other side makes money on the change in the exchange rate over a given period. This method is used when the exchange rate falls sharply.
Conclusion
Swaps play an important role in the financial markets, providing companies and investors with a useful tool for risk management and stability. As financial markets evolve and new technologies emerge, swaps will continue to play a key role in ensuring the efficient functioning of the global economy.
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