Swap Contract

What is swap contact? What is its function and advantage?

A swap contract comprises of a spot transaction leg and a forward transaction leg which are in opposite directions to each other, two equal amount, same period, same method of interest rate calculation, but different currency in exchange. Swap contract can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.

1. Risk hedging for importers and exporters。

For example, an English exporter signs an agreement to receive payment in USD for some merchandise. During that period, if the US rate drop, meaning the English exporter will bear the exchange rate risk. To avoid this risk, the English exporter can sell a 4 month US forward contract for the equal amount. Besides this English exporter, many other multi-national companies also use such swap contract to keep the values of their asset away from exchange rate fluctuation.

2. Currency exchange for investors to avoid exchange rate fluctuation

Investor can use swap contract to start earning from some idle cash. In reality, many banks and financial institutions use swap as a short term investment vehicle to hedge against the drop of exchange rate.