What are swaps?
A swap, basically, is a type of Forward contract. When two agreeing parties make an agreement to exchange an asset at a particular date in future, swap contracts are formed. In swap contracts, one part of the contract agreement is static, and the other part is dynamic as it depends on the future outcome. This future outcome can be anything that these two parties agree upon before making the contract. Price of the stocks, commodity or bonds, changes in the interest rates determined by the Federal Reserve, price fluctuations in the foreign currency exchange rates are some of the general future outcomes on which the swaps are based on. Swaps are not regulated and have a higher risk of defaulting than any of the regulated contracts. However, swap contracts are executed by major banks and are equally credible.
Swaps in the Foreign Exchange Market
There are three types of trades in Foreign Exchange trading. One being the spot market, it is where the trades occur with the currency price at the time of the trade. Second is the forward market, which is an agreement, made between traders to exchange currencies at a price that is agreed upon on a future date. Swap contracts involve both.
A swap in the foreign exchange market, AKA ‘Forex Swap’ is a contract between two traders or agreeing parties to exchange a sum of foreign currency for an equal amount of any other foreign currency based on the exact rate at the time when the contract is made. The two traders will then be bound to give back the original amounts swapped at a later date, at a specific forward rate. This rate is fixed with the currency exchange rate at which the currency will be swapped in the predetermined dates. Changes in the interest rates with time, of the respective currencies, are ignored while swapping. Forex Swaps fundamentally acts as a hedge for both parties and eliminate unexpected or undesired fluctuations in foreign currency exchange rates.
How can one be profitable on swaps fee?
Profitability on swap fee ultimately depends upon the type of swap any trader undertakes. In interest rate swaps one can make high profits by engaging their trades in high volume and high-interest rate. These swaps should be hedged to eliminate or at least mitigate the risk. For instance, if a trader is paying the fixed rate and receiving the floating rate they will be paying a smaller interest if the rate goes up. But they will be receiving a higher floating rate as the receiving rates are higher. These types of swaps make more profit while mitigating risk at the same time.
Likewise in the Currency Swap, currencies are exchanged at the end of the contract, and interest rate coupons are paid based on the interest rate of that country. For instance, you want to receive CAD in the future, by swapping with USD. If the value of the USD drops against the CAD you will be making a profit as the value of the CAD increased so you would be paying less CAD for the same amount of USD and vice versa.
Different types of swaps and their respective fees
There are different types of swap fees. Some of the major swaps include Interest Rate swaps, where the swap fees are dependent on the difference between the volatility of the interest rates. Currency swaps are those where the swap fees are calculated on the price difference between the two foreign currencies and their exchange rates. By using these swaps, traders can secure loans at low costs and hedge them against the fluctuations in their interest rates. Another type of swap is Zero Coupon Swaps. Businesses use these swaps to hedge their loans in which interest is paid at maturity. Banks also use Zero Coupon Swaps to insure their lent assets with end of maturity interest payments. There are many other swaps like Total Return Swaps, Credit Default Swaps & Commodity Swaps which has their own benefits and fees.
How are swaps charges calculated?
Generally, when you hold a position open even after the trading hours and end of the day, you will either get paid or charged interest. This depends on the existing interest rates of the currencies that you exchanged. The swap rates of forex generally depend upon various factors: The price movement of the currency pairs, broker’s commission, interest rates of both the currencies, the behaviour of the market, etc. Let’s consider only interest rates of the currencies and broker’s commission in our example for better understanding.
Let’s say you want to swap 1 lot of USD with CAD for an overnight sell position. The interest rate of USD is 2.0% and the interest rate of CAD is 2.75%. Let’s also consider the broker charges are at 0.25%.
Formula to calculate swap charges
[CS × (D – C) / 100] × Р/365
CS = Size of the contract
D = difference between the interest rates of both the currencies
C = Broker’s Commission
P = Exchange Price
By substituting the values in the formula above,
Swap Charge = [100,000 × ((2.75 – 2.00) – 0.25) /100] × 1.34 /365 = 1.835 USD
So basically when your short position on USD/CAD is swapped to the next day $1.835 will be added to your account.