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.
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.