Swapping

Aside from the buying and selling currencies on Forex markets, there is a surprising amount of swapping taking place. This isn’t of course, the kind of swapping that you may have taken part in with football cards as a youngster; this is all about swapping currencies and commodities.

There are three common forms of swapping that take place on foreign exchange markets; currency swaps, commodity swaps and asset swaps.

Currency Swap

A currency swap is essentially a swap between two currencies for their equivalent monetary value.

For example, a company in Europe may need to acquire a particular quantity of US Dollars. At the same time, a firm in the US may require a quantity of Euros. In this incidence, the two companies could agree to swap currencies directly. This would be done by establishing an interest rate, an agreed amount and a common maturity rate for the exchange. Typically, Forex swaps are negotiable for up to ten years, making them an extremely versatile form of foreign exchange.

Commodity Swap

A commodity swap is an exchange where the cash flows involved are dependent on the value of a particular commodity, such as oil or gold. This is usually used to hedge against the price of a commodity.

In this form of exchange, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved. On the other side of the exchange, a producer wishes to fix his income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity.

Commodity swaps are used frequently by airlines and shipping companies as a means of controlling their oil costs and it is oil which is the focus of the overwhelming majority of currency swaps.

Asset Swap

An asset swap contract follows a similar process to a plain vanilla swap. The difference here is that instead of the underlying basis of the swap being interest rates, the swap involved the exchange of investments.

In a plain vanilla swap, a fixed libor (an interest rate between financial institutions) is swapped for a floating libor. In an asset swap, a fixed investment, such as a bond with guaranteed coupon payments, is being swapped for a floating investment such as an index.

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