Swap is a derivative contract through which two parties exchange cash flows arising from two different financial instruments. Most swap contracts have to do with cash flows relating to a notional amount (such as a loan or a bond), but these can be swapped on any instrument.
Through the swap the underlying instrument does not actually change hands between the parties and each swap consists of two “legs”, or the two reference instruments, of which one is fixed and the other is variable and based on a benchmark interest rate, on a currency exchange rate or the price of an index.
The question what is swap has also other ramifications. Unlike most popular financial contracts such as options and futures, swaps are not traded on an exchange, but are agreements over-the-counter and customized according to the needs of the contractors.
The terms of the swap are described in the contract between the parties, including the values of the underlying instruments, the frequency and the dates of the payments originating from such contract.
Given that swaps are highly customizable contracts and cannot be easily homogenized, the reference market is clearly over-the-counter. However, swap trading is not as illiquid as you might think. Swap trading is in fact one of the most important and most liquid markets in the world with a value of over 540 trillion dollars. To buy swap and sell or simply transfer swaps has become increasingly popular among sophisticated traders.
What is trading swap ?
It can be defined as an interest that is debited or credited every day usually at the so-called cut off time (at 22:00 GMT or 7:00 AM AEDT). It is a differential calculated based on market conditions debiting the interest rate on the currency sold and crediting the interest rate on the currency bought.
As an example of what is swap, if for instance a trader takes a short position on AUDUSD. The trader has sold Australian dollars while Buying American dollars. The interest rate applied by the Reserve Bank of Australia is currently at 1.50%, while that applied by the Federal Reserve is 2.50%.
So what is swap on a short trade on AUDUSD? The answer is 1.00%.
In this way, each trade on the forex market that will be maintained beyond 7:00 AM AEDT will incur in a charge or credit of an amount calculated on a daily basis that represents the rate differential plus a markup applied by the broker in the swap column of the trading platform.
Is it possible to make money when we buy swap and sell?
In finance long-term trading that aims to collect the rate differential is called carry trade. The carry trade is a particular directional trading that exploits the debt position on currencies that have very low rates (EUR, JPY, CHF) and credit on currencies with a very high return (historically AUD and NZD) such as ZAR, MXN and TRY.
What is swap trading in practice?
Another example may be a positioning between the JPY Japanese yen that has an interest rate of 0.00% and the Australian AUD dollar which yields 1.5%. Taking a long position collects the AUD rate and pays the JPY rate at 1.5%.
Imagine the possibility of doing carry trades on currencies such as the Turkish TRY lira that yields 24%, the Mexican peso MXN that yields 8.25% or the South African rand ZAR that yields 6.75%.
The swap rate differential is a certain gain, but why don’t we hear about carry trade anymore?
Simply because it no longer makes much sense to try to earn a few pips a week when the market, especially exotic currencies, is very volatile and is likely to move 100 or 200 pips. Therefore, a trading plan that envisages only a strategy to buy swap and sell is no longer viable.
Before the 2008 crisis we mentioned earlier, carry trade and swap trading was very popular especially against currencies like the Japanese yen. The more popular it became, the more people followed this trade and therefore the carry trade was supported by a mix of gains on the rate differential and gains from market movements. In the current market context, the movements are less directional, but more volatile, as our reference exchange, the AUDUSD or the exchange rate between us and our neighbour New Zealand (AUDNZD), which for several years has remained stable between 1.04 and 1.14.
So is trading swaps still convenient?
Certainly, the classic carry trade strategy has lost friction and attractiveness among the more experienced traders, but it remains a characterizing element of many operational strategies. For less experienced traders, however, the suggestion is to always consider the cost or revenue deriving from the swap and in the case of directional traders it is important to carefully evaluate the impact on the duration of the position.
Swap trading has a fairly recent origin with the first contract between IBM and the World Bank signed in 1981. Since then the swap market has exploded in popularity with swap trading reaching in 1987, only six years after the conclusion of the first ever contract, over $ 860 billion worth of volumes and exploding to over $ 250 trillion in 2006.
In 2008, the swap market was brought in the spotlight during the great financial crisis in the United States following the collapse of the real estate market and the bankruptcy of Lehman Brother. The story behind the origin and development of those troubled years has been told in a popular movie in Australia, the big short, where the events are accompanied with particularly effective scenes.
People buy swap and sell and generally trade swaps for several reasons. In the 2008 American financial crisis, credit default swaps (or CDSs) served as insurance against the default of mortgage holders, but as mentioned before, the types of swaps are various.
Speculators, such as fund managers, buy swap and sell and in general trade swap to bet on the direction of an underlying asset such as interest rates, bonds or currency exchange rates.
For AvaTrade Australian traders trading swap is a relevant topic as it often represents a cost or an opportunity to consider when trading forex.