Forex trading requires knowledge of certain terms. One of them is a swap. What is it and what is it for, read on.
Definition
A swap is the transfer of open trades through the night. It can be positive (commission accrual) and negative (write-off). Most often, they resort to this operation when concluding medium and long-term transactions. No swaps are charged during the day.
How a swap is formed
Every weekday at 01:00 Moscow time, all open transactions are recalculated, that is, they are first closed and then reopened. For each of them, a swap is calculated based on the current rate of the refinancing rate. The smallest percentage is provided for popular pairs (dollar / euro, pound / euro, etc.). Refinancing rates are presented annually. But interest rate swap is charged daily. On the weekend, Forex does not work. Therefore, from Wednesday to Thursday a triple rate is charged.
What is a “swap” in plain language?
To better understand the essence of the swap, you need to understand the mechanism of the trader. At Forex quotes (price ratio) of currency pairs are presented. When buying a pair of EUR / JPI, two transactions occur simultaneously: the euro is acquired and the Japanese yen is sold.
But how can one purchase currency that is not available with dollars or rubles in the account? The answer is simple - using a swap. What it is? Let us consider in more detail what operations are performed when a trader presses the “Open Order” button in the terminal on the terms of the previous example.
- The Central Bank of Japan issues a loan at the refinancing rate.
- The received currency is immediately exchanged for euros. The amount does not pass to the hands of the investor. She stays in the bank. Interest is accrued on it.
- The loan to the Bank of Japan is paid at the expense of interest received from the European Bank. The difference between these rates is a credit swap.
Positive and negative swap
Suppose an investor has opened a long position on a pair of euro / yen. When making a transaction, the interest rate on the euro (0.5%) is first accrued, then the interest on the yen (0.25%) is deducted: 0.5% - 0.25% = 0.25% - a positive swap takes place. If the yen rate is 1%, the swap will be negative. This is the main principle of work at Forex.
This is important to know!
You cannot earn or lose all profits through a swap. What it is? The large leverage offered by brokers and significant fluctuations in exchange rates will block the effect of a small interest rate on the swap, even if it is negative. But to extend your position only because of the positive difference in refinancing rates is not worth it. For violation of the rules of "intraday" trading will have to pay your deposit.
Kinds
In addition to the currency swap considered, there is also a credit default swap (CDS). From the name it is clear that this operation is associated with the provision of a loan for exchange operations in the event of default.
In simple terms, the default swap is an analogue of insurance for the lender. When a bank with a small amount of capital plans to issue a large loan amount to a reliable client, it must protect itself in case of non-repayment of funds. Therefore, in addition to credit, he enters into a risk protection agreement with a larger financial institution at a certain percentage. If the borrower does not return the funds, the lender will receive compensation from another institution.
According to the same principle, swap operations are carried out. The buyer is at risk of non-refund, and the seller is ready to compensate him for a fee. The first party issues the second all debt securities and receives funds against the loan issued. Payment can be one-time or divided into several parts. In one case, the seller repays the difference between the current and nominal value of the obligations, in the second - it redeems the asset from the buyer.
Benefits of CDS
The main advantage of this operation is the lack of the need to create a reserve. In the above example, the bank must create a reserve in case of default of the borrower, which will greatly limit the conduct of other operations. By insuring its risks, the buyer is freed from the need to divert funds from circulation.
CDS allows you to separate credit risks from others and better manage them.
CDS VS: insurance
The subject of a CDS transaction may be any obligation. For example, you can insure the risk of non-compliance with the terms of delivery. Consider an example.
The buyer transferred an advance payment of 80% to the equipment supplier in another country. Delivery must be made within two months. The term is long, and therefore there is a risk of unpredictable situations, loss of funds. In such a situation, the buyer can insure their risks with the help of CDS.
The law does not provide for the formation of reserves in cases where protection is provided through a swap. Therefore, it costs less than insurance. Reliability of the seller is evaluated only by the buyer swap. What it is? A license to carry out activities is not required. CDS do not control the regulator, the exchange, so its design is associated with fewer formalities. Any organization or individual with the appropriate capabilities can become a seller of protection - a company, a bank, a pension fund, etc.
CDS can be applied even when the buyer does not have direct agreements with the borrower. For example, if a company acquires bonds in the secondary market. There is no influence on the borrower, and the assessment of the probability of its default is difficult.
Swaps in the international market can be used even when there is no real credit risk. In this case, we are talking about non-fulfillment of obligations by states (sovereign risk). Theoretically, it is also possible to obtain protection against non-payment of a mortgage, an agreement on which has not yet been concluded, and it is not known whether it will be concluded. But there is practically no point in such insurance.
CDS in the financial crisis
The new tool immediately attracted the attention of speculators. The market was on the rise, no default was foreseen. Why not take advantage of the “free” money? The situation changed in 2008. Banks could not service their debts and began to go bankrupt one by one. Bear Stearns, the fifth largest bank in the United States, was sold for a nominal sum in 2008, and the collapse of Lehman Brothers is considered the beginning of an active phase of the financial crisis.
AIG insurance company was saved at the expense of the US government. Of all the swaps issued ($ 400 billion), only banks needed to transfer $ 22.4 billion. Each financial institution on Wall Street had both great requirements and obligations for CDS. The state first rushed to save the largest institution - JP Morgan Bank, but not directly, but through corporations that bought financial toys.
For all CDS buyers to receive satisfaction, they would have to declare a total default of the largest banks in the USA and Europe. Wall Street, the City of London would simply cease to exist. Even before the crisis, Warren Buffett called all derivatives "weapons of mass destruction." The collapse of the financial system was avoided only through an infusion of public funds. Despite all the consequences of the crisis, the “bomb” of the CDS did not explode, but only made itself felt.
Disadvantages of CDS
All the described advantages are practically unrelated to market regulation. Given the trend of tightening control over financial institutions, over time they will all be lost. The crisis of 2009 prompted government agencies to revise the standards in the field of financial regulation. It is likely that central banks will introduce mandatory reservations to protect sellers.
A default swap will not help solve the problem of default on financial obligations. During the crisis period, the number of defaults increases. The risk of bankruptcy is growing not only for companies, but also for the state. During such periods, buyers of swaps try to get payments from sellers. The latter are forced to sell their assets. This vicious circle only exacerbates the crisis.
Non-swap accounts
The importance of refinancing rates is important to consider when opening a position for a long period (2-3 weeks). In such cases, it is better to use swapless accounts. They are in demand with every broker. However, brokers compensate for the absence of a credit rate with additional commissions.
Conclusion
Briefly summarize all of the above about the swap. What it is? A swap is the difference in interest rates of the Central Bank, which is accrued daily on all open positions. In popular world currencies, the effect is almost imperceptible. But when you open a long position in the "exotic" currencies of third world countries, it is better to immediately transfer funds to swapless accounts.