What is Swap in Forex Trading? (With Examples)
What is Swap in Forex Trading? (With Examples)
The term forex trading is used to describe the act of exchanging one currency for another. However, in reality, forex trading isn’t as simple as that. Let us first revisit what forex is.
The foreign exchange market is referred to as the world’s most liquid market where trades worth trillions take place daily. It is a completely electronic market with no centralized location.
Needless to say, the fx market is open 24 hours a day, 5 days a week only closing its doors for national holidays.
Forex trading is done in currency pairs such as the USD/EUR pair or the JPY/AUD pair. For example, it may cost a trader 1.335 USD to buy one euro in the case of the USD/EUR pair.
Now that you are familiar with forex trading, you can start going in-depth into the topic and learn more about how forex trading works in excruciating detail.
One such part of forex is forex swaps the forex swap examples used in this article will help you understand what swaps are, how they work, what risks they carry, etc so make sure to read carefully to find out more about forex swapping.
Forex Swap: What Ares Forex Swaps?
As you are aware, forex trading is simply the act of exchanging currencies. For instance, a random trader borrows a fixed amount of currency from a different trader and then goes on to lend a different currency to the lender.
This creates a sort of 2-way lending and borrowing cycle that can be looked upon as a contract which is also referred to as the forex swap.
In simpler words, you can say that a swap is an interest that you will either have to pay or an interest that you will earn on a trade that you choose to keep open overnight.
It is a well-known fact that forex markets have to deal in multiple currencies simultaneously which is precisely why the two parties dealing with each other typically come to a mutual understanding or some sort of contract that is signed by both of them.
This is done to ensure that all dealings take place in a fair and professional manner.
Types Of Forex Swaps & How They Are Represented
There are mainly two types of swaps in forex trading:
Long: The long swaps in fx trading means keeping long positions open overnight. A long position in forex refers to the tactic of buying a currency at a particular price and then selling it later at a higher price.
The trader who does this stands to benefit from a rising market.
Short: Similarly, short positions in fx trading refers to buying currencies and selling them in a short period in anticipation that its value will depreciate.
Traders who employ this tactic stand to benefit from a declining market rather than a rising one.
Swaps in forex are represented in pips (point in percentage) which are the representation of tiny measures of changes in a currency’s value and their values are dependant on the instrument that you are trading in.
Forex Swaps Examples
Let us take an example of two traders called A & B who are conducting trade with each other. A has some fixed amount of money in AUD while B also has a fixed amount of money in some other currency like the USD.
During their trade, both A & B come to an agreement that they will exchange their principle and exchange rates which will be dependant on the spot exchange rate of that particular period.
From this example, you can ascertain that A & B will earn from the amounts derived from the net rise or fall in interest and principle.
Calculating Forex Swaps
People trading in forex will often look to speculate on the net values of the investments that they have concerning other currencies.
Let us revisit traders A & B from the above example if trader A has x amount of AUD and trader B has x amount of USD. Let us denote spot exchange with s and x as the amount that both traders have initially.
When A and B will trade, A will pay x AUD to B and B will in return pay x multiplied by “s” USD to A.
Both of them will swap their currencies as soon as the maturity period arrives and bounce back to their initial positions that get multiplied to the USD which B will get back.
But how does this generate profit? The answer to that question lies in the difference between the spot and fixed rates which helps ascertain the net profit or loss this exchange between the traders' A and B has generated.
The Risks That Comes With Swapping
Every coin has two sides and the same goes for forex swapping. Spiraling exchange rates can prove to be very harmful to traders in case of swapping as one party involved in the exchange has to bear the risk of holding one currency for a fixed rate.
The period during which the exchange is being conducted is of the utmost importance as each trader participating in the trade is vulnerable to the volatile conditions of the open market.
Having a backup plan or as some people like to say, a survival strategy can come in handy for traders in case of credit risks.
The best ways of taking advantage of forex swapping are to find out the difference between the interest rate of the currency that you are interested in and taking advantage of it.
The currency whose value shoots up all of a sudden will prove to be beneficial to the receiver. The significance of that benefit is dependent on the forward and current exchange rate.
Many forex swaps examples have brought up the fact that currency exchanges end up being beneficial to both parties if the rates are appreciating and the opposite of that when the rates are depreciating.
The only risk that forex swaps carry is the unfavorable conditions of the open market that can lead to both the parties losing their revenues.
Traders should be completely confident in the period in which they partake in forex swapping to ensure the best results.