A swap contract is an agreement between two counterparties regarding exchange of financial instruments within specified time frame under conditions, stipulated by the contract. In general a swap could be considered as a portfolio of forward contracts, concluded by the same parties.
- Swaps are used for
- Management of financial liabilities;
- In order to correct and compensate mistakes;
- Risk hedging;
- Balancing of currency portfolios;
- Profiting from interest rates spreads;
- Cash flow management
Usually swap contracts assume equal rights of counterparties and in simpler words mean future exchange of commodities, cash flows (as an interest rate swap), predetermined volumes of foreign currency etc under conditions, defined today. So a swap partially uses future price, which is unknown on the moment when parties enter into a deal. It gives possibility to earn potential profit or to prevent potential losses on spot and forward markets.
Execution of mutual exchange under accepted conditions is obligatory for swap deals. It’s done through relative accounting transactions. But, of course, rights under a contract could be reassigned to third parties.
A forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward). If initial transaction in exchange pair is foreign currency purchase and following transaction is currency selling then a swap called “buy and sell swap” (buy/sell or b+s). Opposite to that if currency is firstly sold and later on bought back – it’s called “sell and buy swap” (sell/buy or s+b).
Traditionally both phases of swap deal (also called legs) are conducted with the same counterparty but nowadays it’s possible to arrange a combination of currency conversions for the same amount with different value dates and with different counterparties.
With regard to the time frame of swaps they could be divided in following categories:
Standard swap. Most common are one week swaps (s/w swap) when first deal under the exchange contract is executed on spot market and reverse deal is done as a week forward.
Short swaps consists of two spot deals – initial one is TOM (next day value) and reversal is standard spot (second day value).
Long (forward) swap is combination of two outright forward contracts where execution date of second (reversal) forward is later than that of initial forward.
Relating to FX-swaps value date is a date of initial deal execution and a date of reverse deal closure is called swap termination date. Commonly swaps are arranged for a period less than one year.
The most common use of FX swaps is for institutions to fund their foreign exchange balances. Even the Bank of Russia introduced the system for refinancing the Russian credit institutions using buy/sell overnight swap transactions. The objective of this measure is to broaden the range of instruments for the regulation of the short-term liquidity of the banks and to support the stability on the Russian money market.
Financial swap allows money market participants to change aspects of their cash flows. An interest rate swap is intended to exchange cash flows relating to the interest payments on a loan; the most popular is exchange of a fixed rate loan to a floating rate loan. Currency swaps entail swapping both principal and interest between the parties from one currency into another at a rate agreed at inception.
Financial swaps are traded over-the-counter, directly between two parties, without going through an exchange. Therefore, they are subject to counter-party risk, like an ordinary contract. Sometimes financial guarantees of professional intermediaries are provided for the execution of liabilities under a swap agreement in order to reduce risks. More over involvement of middlemen ensures confidentiality of transactions. The cost of finding counterparty (either directly or through an intermediary) and drawing up an agreement with them is major part of swap expenses.