Swap in Finance: Functioning and Benefits

Understanding with the example of currency swap

A swap, in French translated as "exchange", is a contract established between two parties to reduce exposure to risk. Imagine, for example, that a French company signs a contract for 100,000 dollars for the purchase of materials, payment for which will occur in 6 or 12 months. At the current exchange rate, 1 euro is worth 1.10 dollars. Therefore, the purchase should cost the company about 91,000 euros if it paid now. However, exchange rates fluctuate significantly. If, by the time of payment, the value of the dollar increases relative to the euro, the operation will be more expensive. Suppose 1 dollar would be worth 1 euro, the purchase will finally cost 100,000 euros, an increase of nearly 10%. To avoid a surge in cost that it cannot anticipate, the company will freeze the exchange rate by opting for a currency swap (a "currency swap"). Specifically, the company will borrow from a third party (often a bank) the amount in dollars it needs at the prevailing exchange rate. In return, it will lend the equivalent sum in euros. In our example, it will therefore borrow 100,000 dollars and lend 91,000 euros for a period set in advance (the deadline being close or concurrent with when it will have to pay for its purchase). Throughout this period, the 2 parties will pay each other interest before repaying at maturity. The entire operation is set out in a contract: the swap.

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Swaps: flows of interest rates

Swap contracts take the form of financial derivative products that aim to exchange the performance of one rate or asset for another. Therefore, you can find various types of swaps dealing with different underlying assets: currencies, interest rates (for example, to exchange a variable rate for a fixed rate), credits... Each party uses these contracts to hedge against financial risk linked to the evolution of one or more rates. Hence they are commonly found among finance actors who use them daily to smooth out their risk and improve their visibility on various operations. Beyond the practical aspect of managing a company's financial flows, they are also frequently encountered on the stock market when participants take speculative and very risky positions. Swaps then allow them to hedge themselves. The biggest players in swaps are commercial banks. But since 2010, central banks of various countries also use them to create liquidity and stimulate their economies without tapping into their reserves, thanks to "swap lines". For instance, the ECB (European Central Bank) and the FED (Federal Reserve) regularly conclude such contracts, borrowing dollars and euros from each other, especially in times of crisis. Such agreements also exist with Canada, Japan, China, Sweden, etc. According to economics professor Yves Jégourel in his book "Derivative Financial Products", "Swaps are the most prevalent derivative products on the markets." For 2022, the ISDA (International Swaps and Derivatives Association) estimates that volumes have jumped by nearly 27%, reaching almost 300 billion dollars in volume for rate products.

The different types of Swaps

The principle being the exchange of assets, there are several types of swaps. These include:

- Interest rate swaps: these are the most common contracts. Companies use them, for example, when they believe that rates will fall and they have borrowed at a fixed rate, or vice versa.

- Currency swaps are used to hedge against unfavorable exchange risks by making cross-currency loans with interest.

- Credit Default Swaps (CDS), often used by banks, allow them to rid themselves of credit default risk, somewhat like insurance as the institution then pays a premium.

- Commodity swaps, concluded between a company and a bank, also aim to fix prices. Thus, on the day of payment, if the market price of the concerned commodities is higher than the agreed price, the bank pays the difference to the company to fix their purchase price. Conversely, the company pays the difference to the bank.