A swap is a financial transaction in which two parties agree to exchange cash with each other over a period of time. The origin of this transaction is back-to-back loans. For example, a French company lends a 5-year loan in French francs to an American company at a 10% interest rate, and the American company in turn lends an equivalent loan in U.S. dollars to the French company for the same 5-year period at an 8% interest rate, and through this process, the two companies exchange principal and interest payments, which is the same as the French company exchanging a certain amount of francs for a certain amount of dollars at a fixed exchange rate. In essence, this is a forward foreign exchange transaction.
Advantages and disadvantages of swap trading:
1. Swaps have their own advantages compared to other derivative instruments
First of all, swap trading combines foreign exchange market, securities market, short-term money market and long-term capital market operations, which is both an innovative tool for financing and financial management.
Secondly, swaps can meet the requirements of traders for non-standardized transactions and are widely used.
Third, hedging with swaps eliminates the need for daily management of positions required for other financial derivatives, making them easy to use and quick to transfer risk.
Fourth, swap transactions have flexible maturities of arbitrary length, up to several decades.
Finally, the creation of swap warehouses makes banks the main body of swaps, so the swap market is more liquid.
2. Disadvantages in swap transactions
There are many risks associated with swap trading itself. Credit risk is the main risk faced by swap transactions, as well as the risk that swap parties and intermediaries cannot fulfill their contracts due to various reasons such as default and refusal to pay. In addition, there is also the risk of swap interest rates for both buyers and sellers, as the swap term is usually as long as several years.