Stock Market Guide to Swaps when Investing
“Contracts for Difference” are popularly known as “swaps”, with the most common types being Equity Swaps and Interest Rate Swaps. All contracts for difference have as their basis an exchange between two parties that allows each party to realize a benefit, not necessarily a profit, from the exchange. It may be that one party seeks to reduce their level of risk engendered by their ownership of variable rate securities, and in effect partners up with a second party who is endeavoring to reduce the fixed component of their overall position. These different types of derivatives are in many cases too exotic for the average individual trader and are chiefly used by large institutional investors such as hedge funds, investment and commercial banks, and major finance houses who employ trained arbitrage specialists to conduct the trades and enter into swap contracts.
Among the more esoteric contracts for difference are variations on interest rate swaps known as Basis Swaps and Constant Maturity Swaps. In the former, two floating rate financial instruments are exchanged with the instruments being denominated in the same currency and the floating rate payments have different base references. In Constant Maturity Swaps, or CMS’s, the floating leg of an interest rate swap contract is periodically fixed against a point on the Swap curve. Therefore, the purchaser can fix the duration of the cash flows received.
Currency contract for difference swaps are also popular due to their relative simplicity. In a typical cross-currency swap, two equally valued amounts of different currencies are swapped, with the contract concluding at a set future date when the currencies are traded back. Although the per-currency amount remains the same, the value of each currency relative to one another may have changed. FOREX swaps are different, in that they are basically on the spot foreign exchange transactions in which a trader with an overabundance of one currency will swap a set surplus amount into another currency, thereby increasing liquidity and providing a measure of protection against adverse fluctuations in the value of the original currency.
Swaps are a popular tool for companies looking to fulfill certain needs on their corresponding markets, as well as to gain advantage over their competitors based on assets and market reach. Some companies regularly need to operate in conditions with significant fluctuations in their interest rates, which is the perfect opportunity for introducing a swaps contract to mitigate the negative effects. However, this is typically exclusive for larger entities with a stronger financial portfolio, such as financial institutions and major corporations. The conditions needed to make a swap an attractive prospect can sometimes be prohibitive to smaller organizations, which is why this type of activity tends to be concentrated into the higher end of the market.
A major difference between swaps and other types of investment contracts is that they are typically negotiated privately between interested parties, instead of being traded at an exchange. This tends to make them a more attractive option for entities with larger asset portfolios who can comfortably afford to participate in the market. For that reason, it’s relatively rare to see individuals taking part in swaps trading, although there are certainly precedents for that. The risk of having one party default on the contract is a major contributing factor to the exclusive nature of swaps, with companies typically vetting the entities they engage with for such contracts carefully. An individual with a proven track record and a significant portfolio may still be able to find attractive deals on the swaps market.
A specific variant of swaps involves exchanging payments with two different currencies. The exchange rate at the time of initiating the contract is used to calculate the corresponding sum in the opposite currency, and the actual swap occurs at the beginning and end of the contract. These types of swaps are very common among companies based in different countries, which typically have the extra leverage necessary to profit from trading their own local currency against a foreign one.
It’s not uncommon for companies to specifically engage in other types of trade deals to acquire assets which are useful for swapping, with the specific goal of utilizing them for that purpose. Companies looking to extend their physical presence into another country are typical candidates for this, as a swap deal can afford them more flexibility with the foreign currency that they need to integrate into their operations.
Although formal Contracts for Difference are not legal in the United States due to SEC regulations, they are frequently utilized in the rest of the world. The SEC rules that forbid formal Contracts for Difference likely concern the relatively low margin requirements, as low as 1% in some contracts. While this low margin requirement allows traders the possibility of greatly magnified profits, it also can lead to exaggerated losses and sudden margin calls that force the trader to close out their position.
It’s also important to note that a swap deal typically requires a full buyout, or compensation with an equivalent swap deal, in order for a party to back out of it. This makes swaps a long-term engagement with some potentially serious financial implications for the company entering the deal. It’s also another reason for the restrictive nature of this corner of the market, and the relatively exclusive popularity of swap deals among entities with more financial flexibility and a stronger asset portfolio.