How to trade using swaps

How to trade using swaps
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Very often you hear how big the Forex market is, with a daily trading volume of $5.1 trillion every day. No one can dispute that is a really huge number, but reading between the lines will show you that the volume of trades has dropped. According to the Triennial Central Bank Survey by the Bank for International Settlements, the Forex market had a daily trading volume of $5.4 trillion back in 2013.

The decline in total trading volume has decreased because spot trading on the Forex market has reduced significantly, but Forex derivatives have increased. Back in April 2013, Forex derivatives had a daily trading volume of $2.3 trillion, but the volume increased to $2.7 trillion in April 2016. Forex spot transactions by traders amounted to $1.7 trillion. Looking at the figures, you can see that Forex derivatives accounted for more than 50% of all the Forex market trade volume, and not the retail or spot trading.

By now, you must be curious about what these Forex derivatives are, and one of the most significant is the Forex swap which accounted for $2.4 trillion while cross currency swaps accounted for the other $0.3 trillion in Forex derivatives. As the name suggests, Forex swaps simply imply an exchange of foreign currency by two parties, but there’s a lot more to it. To begin, let’s look at the structure of a Forex swap.

WHAT IS A FOREX SWAP?

To understand how Forex swaps work, it’s best to use an example. By definition, a swap requires 2 parties, and they are referred to as counterparties, so let’s assume companies X and Y are the counterparties in our example. Company X is based in Tokyo but also has a subsidiary in London, where company Y is situated, but company Y, too, has a subsidiary in Tokyo. This would mean that both of these companies need to pay their employees in 2 different currencies, the Japanese Yen and Sterling Pound.

The companies have, in the past, been operating by exchanging currencies on the spot Forex market at the exchange rate at that moment. However, Company Y is worried about the value of the Sterling Pound because there’s going to be a conference by the European Central Bank regarding a change of interest rates in a few days, and so is company X in Tokyo. If the value of the Pound drops, company Y would have to spend more pounds to buy Yen for its Tokyo operations, and company X is worried about the opposite – the pound getting stronger. Neither of the companies want to caught off-guard by a drastic change in interest rates that affects the value of the Sterling Pound, so they enter into a Forex swap.

In the Forex swap, company Y agrees to sell company X, say, £10 million at the current exchange rate for GBP/JPY. That way, company X is able to pay its workers in London despite the changing Forex rate for the GBP/JPY. At the same time, company X sells company Y Japanese Yen worth £10 million so that Y can pay its workers in Tokyo without having to change currency.

To settle the debt which the companies owe each other, the companies use a forward contract to determine the exchange rate at a specified time in the future. By using a forward contract, both companies are able to know the exact exchange rate at which they will either buy or sell the GBP/JPY pair at.

As you can see, a Forex swap is a two-legged transaction, involving a simultaneous spot Forex transaction and a forward contract.

HOW DOES ALL THIS HAPPEN?

Companies X and Y don’t know each other, so one wouldn’t know that the other is in a similar predicament, so the companies approach a swap bank. The swap bank’s role is to match counterparties, acting as an intermediary to know the needs of either counterparty. In most cases, the counterparties involved may never even know who participated on the other end.

Unlike other Forex derivatives like currency swaps which may take years, Forex swaps are often completed within the same week or even in a few days. The whole idea being to avoid any anticipated volatility in the exchange rate for a short period.

WHY DO COMPANIES ENGAGE IN FOREX SWAPS?

The main purpose of a Forex swap to the counterparties is to offset risk. Neither company X nor Y knows what the ECB decision is going to be, it might work in favor of one of the company or the other. For example, a stronger Sterling Pound would mean company Y would use less pounds to turn into a similar amount of Japanese Yen, making it easier for the company to run its Tokyo operations and vice versa. However, in business, companies don’t like to take any risks and would prefer to maintain a predictable exchange rate, hence the Forex swap.

WHY DOES THIS MATTER TO RETAIL FOREX TRADERS?

The above example represents a Forex swap for institutions or companies that have the need for the actual currency, but not for speculative traders. A speculative trader is not interested in the actual delivery of the currency, but is only after the fluctuations in price. What most traders don’t realize is that their Forex broker participates in a form of Forex swap every time they hold a position overnight past the closing time of 5pm EST.

In Forex transactions, the trader is supposed to deliver the currency bought or sold in 2 days, but speculators have no intention to do so, and the brokers know this. Thus, the broker swaps the open positions for an equivalent forward contract at the start of the next day. This is known as a tomorrow- next (tom-next) procedure, and in the process incur a tom-next adjustment or cost of carry.

This adjustment is calculated by comparing the interest rates of the currencies involved. If, say, the base currency has a higher interest rate and the trade was long, the cost of carry will be positive. For example, if the trader was long on the AUD/USD where interest rates are 1.5% and 0.75% respectively, then the trader would earn 0.75% on the value of the trade. And the broker will then credit this carry into the trader’s account.

CAN YOU MAKE MONEY JUST FROM SWAPS?

In order to profit from swaps, there are 2 things to consider, how profitable is the trade and what is the difference in interest rates. If you’re holding onto a losing trade day after day, then you would be losing more money on the trade itself than you’re making on the swap.

Secondly, you should try to identify currencies with a huge difference in interest rate. In the above example, a 0.75% difference may not bring in significant returns, so you should find currencies with a larger difference, preferably the exotic pairs like USD/ZAR with interest rates of 0.75% and 7% respectively. In this case, going short on the USD/ZAR would earn you a swap rate of 6.25% daily. If you caught a massive downtrend in the USD/ZAR, then you could make a lot of money on the trade itself in addition to the carry.

Now that you know about this new avenue for making money, it’s up to you to do your research and find a balance between interest rates and the success of the trade itself.

Article written by Martin Moni
 

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