What is an exchange and how does it work?

The exchange of ideas (CIRS)

the exchange ideas (Currency Interest Rate Swap or Cross Currency Swap) allows you to exchange the interest and value of an underlying in one currency against its value in another currency. Since payments are made in the currency of the counterparty, this type of swap involves exposure to both the interest rate and the foreign exchange market.

This type of swap, comparable to a cash transaction, takes place in three ways according to the rates agreed for the exchange of payments:

  • The exchange rate that refers to fixed rates in each of the two currencies: we therefore speak of currency swaps or even currency swaps

  • The exchange that provides a fixed rate in one currency and a variable rate in the other currency (cross-currency swap)

  • The exchange which provides variable rates in each of the two currencies.

Currency exchange example

The most emblematic example of this type of swap was entered into in 1981, when the World Bank accepted a bond in USD, and then exchanged its payment obligations in dollars with the American company IBM in exchange for covering the debt of the company issued in German marks (DM) and Swiss francs (CHF). This swap allowed the World Bank to increase its exposure to the currencies of Switzerland and Germany, which had interest rates ranging from 8% to 12%, compared to 17% in the US, while IBM covered its obligations. in these currencies.

Credit Default Swaps (CDS)

the Credit Default Swap (or credit default swap) hedges the default risk of a bond issuer against periodic and regular payments during the term of the swap. Credit default swaps work differently than other financial swaps and are often compared to an insurance policy due to the similarities to this product.

In reality, these tools carry their own risks. One of the factors behind the 2008 financial crisis involved credit default swaps when issuers were unable to cover mortgage defaults.

Credit Default Swap Example

Suppose that in exchange for an attractive interest rate (underlying value), the “FP” pension fund decided to invest by lending a large sum to ABC company. To mitigate its risk, FP (buyer) decides to open a credit default contract with an insurance company (issuer) in exchange for a fraction of the interest received on its investment. With this exchange, FP manages to protect itself from the non-fulfillment (non-payment) of the ABC company, transferring the obligation to cover losses to the insurance company.

exchange of goods

A exchange of goods it is an agreement in which the cash flows to be exchanged are linked to the price of an underlying commodity. This swap provides protection against fluctuations in commodity prices. Although primarily oil-based, commodity exchanges can also be based on precious metals, food products such as grain or livestock, and energy reserves such as natural gas.

In a commodity swap, one of the parties (user of the commodity or financial institution) would guarantee the maximum price of the underlying and accept payments on the fixed price for a specified period. In return, he would receive a stream of variable payments based on the market price of the commodity, an obligation usually tied to the manufacturer.

Other types of trade-ins

  • The bases of exchange : allows you to exchange two variable rates indexed on short-term rates, in the same currency or in two different currencies
  • The constant-term swap interest rate : allows you to exchange a variable rate indexed on short-term interest rates with another variable rate indexed on a medium or long-term interest rate
  • The asset swap : is the merger between an interest rate swap and a fixed rate bond creating a synthetic floating rate bond
  • Total return swaps : allows you to exchange the income and the risk of changes in the value of two different assets over a given period of time
  • Inflation swaps : the exchange of a fixed or variable rate against an inflation rate
  • Stock exchanges : works in the same way as the interest rate swap
  • Exchange of curves : Single currency interest rate swap (variable versus variable) that bets on the shape of the yield curve.

How to use swap in forex trading?

Traders with an online forex trading account seek to profit from currency swaps as part of a long-term trading strategy called financial speculation on the interest rate For this strategy to be effective, traders must select the currency pair whose respective interest rates will be furthest apart and buy the more profitable of the two.

Traders must closely monitor the state of trade and the evolution of exchange rates around the world to generate profits from this type of trading. Also keep in mind that a succession of short positions held overnight will have the same financial consequences as a position held throughout the period (with the exception of brokerage fees which may be higher when you constantly renew positions).

You can forex trader through our platforms and intuitive apps with our free demo account or by opening a real trading account, without any risk to your capital.

The pros and cons of exchanges

Swaps are used not only for hedging transactions tending to cancel or reduce the risk exposure of a company or an individual, but also for speculative transactions.

The main drawback of swaps remains related to counterparty risk. Indeed, it is always possible that the counterparty does not fulfill its payment obligations. By opting to trade for speculative purposes, you also risk suffering losses when your predictions are incorrect.

Conclusion

Swap is a complex financial instrument used mainly by professional investors. This currency market mechanism is also a financial derivative product that allows for cash transactions and credit enhancement. It is used by some traders to generate long-term forex profits by taking advantage of the interest rate differential between currencies through the “carry trade” strategy. However, retail investors are advised to try to understand the underlying mechanism by incorporating it into their portfolio.

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