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Swap

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1. What is it?

Swap literally means an exchange. For finance purposes, it’s a derivative in which two counterparties exchange positions and assets in order to reduce or mitigate risks, especially regarding their profitability. A swap contract may have, as its object, currencies, financial indexes, commodities and much more. Contracts are traded in OTC markets and have no standards, so they cannot be transferred to third parties nor being executed before the established expiration.

In Brazil, the most common swaps traded include:

1. Interest Rate Swaps

This kind of swap provide a way of exchanging assets with pre-fixed rates for assets with floating rates (CDI), or vice-versa. For instance, an investor bought a depository receipt from the bank A, and wants to be protected from increasing interest rates, so he can make a swap with the bank B using floating interest rates. This way, if the benchmark interest rates hike, he can make profits from the bank B, with some losses from bank A. If benchmark rates fall, then the opposite happens.

2. Index Swaps

Provide the exchange of cash flows between different indexes, such as inflation rates, like IPCA and IGP-M, or even stock exchange indexes, like Ibovespa, IBRX, etc.

3. Currency Swaps

This swap use currencies as object of exchange. A company, for example, can exchange a loan in dollars for a fixed interest rate for an equal loan with another interest rate in euros. During the contract, payments are made at a fixed rate for each currency.

4. Commodity Swaps

An exchange of assets based on goods like corn, soy beans, coffee, etc.

5. Forex Swaps

In this swap, investors can exchange the dollar exchange rate for DI rates. We’ll detail this kind of swap further.

The Forex swap aims of dealing with the difference between the simple interest rate of the base currency and the dollar exchange rate. The simple rate is equal to the DI interest rates between the date of the operation and the maturity date. The exchange variation corresponds to variation of the exchange rate of U.S. Dollar, asking price negotiated at freely negotiated rates observed between preceding the date of operation until the maturity date weekday segment.

This contract leads to the so-called ‘exchange coupon’, or the interest rate found from the difference between the DI interest rate and the dollar exchange rate, and is nothing more than the BRL gains from dollars invested in Brazil.

There are two possible financial positions for swap operations. One can be bought (long) or sold (short).

Bought Position (Long): the investor actually sold the exchange coupon plus the dollars exchange rate and bought the DI rates.

Sold Position (Short): the investor sold the DI rates and bought the exchange coupon plus the dollars exchange rate.

By the expiration date, those holding a short position will be given the amount equivalent to the positive exchange coupon, if DI rates exceeded the dollar exchange rates for the entire period of investment.

Otherwise, if the exchange rate changes has exceeded the valuation of the CDI rate, the investor will pay the amount corresponding to the negative exchange coupon.

How does the Forex swap works?

An exporter generates revenues in dollars, but keeps paying debts in BRL, updated by DI rates. So it decides to exchange the dollar exchange rate risks for DI risks.

Another company, by its turn, generates revenues in BRL, which remain invested under DI rates. However, its debts are in dollars. The structure of this second company is exactly the opposite of the first’s, so it decides to exchange DI related risks for dollar risks.

Both companies can trade a swap contract, although the operation must be intermediated by a bank or financial institution. Sometimes a swap can be traded between a company and the bank itself, if the bank absorbs risks as a counterpart.

Once the operation is completely set up, the swap needs to be registered in Cetip (with no guarantee) or at the stock exchange (with possible guarantees being deposited by the counterparts).

Currency Control

Brazilian Central Bank many times make a ‘reversed’ Forex Swap operation, in order to balance  dollar drops and highs. That means the Central Bank commits to purchase a certain amount of dollars in a same day, on the future, for a forward exchange rate, established when the operation starts. Thus, this operation is actually a swap, where the Central Bank remains with the dollar exchange rate float (it expects the foreign currency to soar) and the banks are paid back Selic interests (long in contracts). The name ‘reversed’ comes from the fact that once such an operation occurred in reverse order, ie the BC securities offered to the market that paid the dollar variation and received remuneration in the Selic.

The Swap Exchange reverse equals buying dollars in the futures market, causing the dollar to fall or stop rising. As the BC become sellers of dollars in the future, other investors will become buyers, increasing demand for the dollar making dollar fall.


2. Characteristics

Forex Swaps traded in BM&F have the following characteristics:

Contrato

Contract size US$ 50.000,00
Min Change 0,01 rate point
Max change Percentage set by BM&F

Maturity

The maturity is set up by BM&F. Each authorized date will have a specific serie. By the maturity date, expiring series cannot be traded.

Periodic Updates

For Forex swaps, there is no daily updates, but periodic. BM&F stipulates dates for each serie of swaps, when positions held by counterparts are updated based on BM&F’s reference index. Any value from these updates needs to be paid in the day after.

Guaranty margins

It is a value deposited in cash or notes which will covering any noncompliance of an investor in daily settlements. Usually to operate futures, the investor is forced to deposit a guarantee to mitigate risks. The margin is defined by the stock exchange, according to the analysis of the futures market.

The assets accept as guarantee include cash, gold, government or private bonds, letters of pledge and quotes at funds.

Operational costs

Expenses from investing in Forex Swaps include:

Brokerage – it can change depending on the broker. However, most of them use the basic operational fees, stipulated by Bovespa. In this case, costs reach 4% for regular operations.

Stock exchange fees – Exchange fees, registration, permanence and settlement rates, calculated by the BM&F itself are charged as follows:

Emoluments: The fees charged by the BMF values ​​related to trading services. They focus on contract negotiation (opening or closing position before maturity), exercise of options, registration and early settlement and assignment of rights procedure. In the normal operations of currency swap is charged BRL 0.80. In matched operations, is charged BRL 0.40 for each transaction.

Liquidation charge: this charge regards to the liquidation of the contracts by the expiry, on top of clearing expenses. Usually, this charge is a fixed value, and has nothing to do with the volume of contracts negotiated. Forex contracts pay US$ 1.00 each.

Clearing fees: include all costs for following positions and receiving reports and filings made by the clearing house, as well as operational costs for holding inactive positions on derivatives. It affects all positions opened in contracts traded in the primary market (except for options and minicontracts) and OTC contracts. The fees are daily updated, and charged in the last work day on each month, by closing the positions or every time an investor transfers all positions to another one.

Fees are based in the number of positions opened by the calculation day, and can vary depending on the volume of contracts traded. Forex Swaps are charged 0.0035% a day, per contract.

Registry charge: a value charged to register the operation on the clearing house, that only applies to deals that open or close positions before the expiry date, and charged one day after those events. It is set at US$ 1.00 per operation.

Liquidation

By the maturity date, all positions that remain opened, after a last adjustment, wil be financially executed by the stock Exchange. The liquidation value of the position will be the difference between the value of the coupon tip and the value of the tip end value, multiplied by the exchange rate on the day before. If the value of the coupon exceeds the value end of the tip end value, liquidation value will be credited to the buyer (long) and debited to the seller (short). But the contrary, the settlement amount will be credited and debited to the seller to the buyer.

Mini Swap

Operating with Forex Swaps demands a huge capital, either to meet initial margins or the contract sizing. A solution found to make it available for small businesses and investors was creating a “mini” Forex swap.

Rules and features for minis remain basically the same as traditional Forex swaps, except for the contract’s size. A mini Forex is equal to only 2% of a regular Forex swap. In other words: while Forex Swaps worth US$ 50,000.0 each, “mini” swaps worth US$ 1,000.00.

So the most important advantage of minis is the much lower capital involved, being the lowest operational, accessible to small investors and businesses of any size costs.. Also, mini Forex swaps are daily adjusted, not periodic like the bigger versions of the contract.


3. Example

Let’s suppose a company has R$ 1,000,000.00 in depository receipts invested at 100% of DI rates, to be executed in 45 days. DI rates reach 8.5% a year, so consider the figures below:

Total investment R$ 1.000.000,00
Days to maturity 45
Annual DI rate 8,50%
45 days DI rate 1,47%
Exchange rate in 45 days 2,50%
Annual Dollar Spread 10%
45 days dollar spread 1,27%

As this company has debts in dollars, it prefers to swap DI rates for exchange rates, expecting its debts in dollars do not exceed the profits from its investments. So, it takes a short position by selling DI rates and buying the dollar exchange rate plus the dollar spread. So this swap results into:

1. DI rates profits

To find profits from investing R$ 1,000,000.00 during 45 days, it is just multiplying the totals for DI rates for 45 days:

R$ 1.000.000,00 x 1,47% = R$ 1.014.674,48

So, by the expiration date, the investment is to generate profits of R$ 14,674.48 in a total withdraw of R$ 1,014,674.48.

2. Swap

As the company is short on the swap, it can receive, by the maturity date, the dollar exchange rate plus the dollar spread, as well as paying DI rates.

DI rates payment = R$ 1.014.674,48

But the amount to be received by the company is larger:

= (dollar exchange rates + 45 days dollar spread) * Principal + Principal

That leads to:

= ((1+2,50%) * (1+1,27%)-1) * R$ 1.000.000,00 + R$ 1.000.000,00 = R$ 1.038.004,69

3. Operation results

By the maturity date, these are the numbers:

Payments of R$ 1,014,674.48

Revenues of R$ 1,038,004.69

Thus: R$ 1,038,004.69 – R$ 1,014,674.48 = R$ 23,330.20

This way, the company receives the equivalent to the exchange rate move plus the spread. In this case, the difference was R$ 23,330.20. However, debts also increased in the same way, so the operation served as hedge.

*Taxes and transaction costs have been disconsidered.


4. Profitability and risks

Profits and risks from investing on spread futures are related to the dollar exchange rate and DI rates. Thus, we cannot precisely determine whether we are making profits or losses. As a derivative, the spread future can be either used as hedge or for speculating. If the Dollar vary greatly, the investor or company can have high profits or high losses, depending on its position (long or short).


5. Taxation

Forex Swaps pay income taxes as they were regular fixed income investments, accordingly:

  • Investments of up to 180 days: 22,5% (only over profits)
  • Investments from 181 to 360 days: 20% (only over profits)
  • Investments from 361 to 720 days: 17,5% (only over profits)
  • Investments over 720 days: 15% (only over profits)

Calculations are based on the positive results of liquidation or execution, as well as possible amounts to cover losses from swap operations. Losses made from swaps cannot be compensated using net profits from other variable income assets.


6. Advantages

  • Hedging against dollar exchange rates or DI interest rates;
  • Possibilities of speculating on dollar hikes.

7. Disadvantages

  • Daily or periodic adjustments;
  • Guaranty margins;
  • Income tax;
  • High risk profile.

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