swaps

Swaps are usually used to manage risk, earn profits, or protect one's investments. While the idea might sound complex, the concept plays a role in global finance. From farmers to hedge funds, many use swaps daily. 

In this article, Wealth Professional Canada will look at what swaps are in the context of wealth management. We’ll also discuss common examples and how they can be used by professionals to improve their services and attract more clients. 

What are swaps in wealth management? 

Swaps are financial contracts that get their value from something else, often called an “underlying asset.” This asset could be:  

• stock 
• bond 
• commodity 
• interest rate 
• currency 
• market index 

Instead of owning the asset itself, you are trading a contract based on how the asset performs. Swaps are also commonly used for hedging, speculation, and arbitrage. 

The purpose of a swap is to let people manage financial risk or speculate on price changes. These contracts are widely used by businesses, investors, banks, and even governments. There are several major types of swaps. Each works a bit differently, but they share the same idea: their value depends on another financial item. 

Want to better understand how this financial contract works? Watch this clip: 

If you want to dive deeper into what swaps are, you should already know the basics of trading. As a reminder, trading involves buying and selling different assets with the goal of earning a profit. 

OTC swaps 

Over-the-counter (OTC) swaps are contracts traded directly between two parties, outside of formal exchanges. These include many forwards, swaps, and some options. OTC swaps offer flexibility in terms and structure but come with higher counterparty risk. 

These also have less regulatory oversight compared to exchange-traded swaps. 

What are examples of swaps? 

Check out these two examples of swaps: 

1. Options 

Options give the buyer the right, but not the obligation, to buy or sell an asset at a specific price before a certain date. There are two main types of options: 

• call options: allow the buyer to purchase the asset 
• put options: allow the buyer to sell the asset 

This type of swap is used for both protection and speculation. A common example is when investors buy put options on a stock they already own. This allows them to limit potential losses if the stock drops, while still keeping the chance to gain if the price rises. 

Options give more flexibility since the buyer is not required to go through with the deal. 

To learn more about these options and other insights about swaps, watch this video: 

This video lesson is part of chapter 10 of the Canadian Securities Course (CSC). Check out this guide for more info about the CSC and how it can help push your career. 

2. Forward 

The next type of swap is a private contract between two parties who agree to buy or sell an asset at a swap date for a price they set in advance. Forward contracts are not traded on public exchanges and can be customized to meet specific needs. 

Flexibility makes forwards useful in business settings, but they also come with higher counterparty risk because there is no third-party clearinghouse. For instance, a local company expecting to receive revenue in United States dollars, might use a forward contract to lock in an exchange rate. 

This helps the company avoid losing money if the Canadian dollar rises before the payment is received. 

How swaps work in a wealth management strategy 

In a wealth management setting, swaps are often used to reduce volatility or protect a client’s investment. They can also allow for strategic exposure to certain market movements. 

Some clients might use swaps to generate income through writing covered calls. Others might use interest rate swaps to protect fixed income holdings when rates are rising. 

Here are some of the main ways swaps are used in portfolio strategy: 

• Hedging against downside risk: Options can be used to lock in a minimum sale price on a stock or index. This can reduce the impact of market corrections. 
• Managing interest rate exposure: Swaps can be used to convert fixed rate payments to floating or vice versa. This helps reduce the impact of changing interest rates. 
• Targeting tactical exposure: Swaps can give access to equity or commodity markets without direct ownership. This can allow quick and low-cost exposure. 
• Generating income: Covered call writing is a strategy that can bring in extra yield on top of dividend payments. 

Technology platforms have made it easier to model the impact of swaps on a portfolio, but understanding the product structure is still needed. Financial advisors should consider a client’s risk profile and investment goals before recommending swap exposure. 

Why swaps matter 

Swaps are used in a variety of settings, like banks, hedge funds, pension plans, and even corporations looking to stabilize their earnings. Let’s look at a few reasons why swaps matter: 

Risk management 

Although swaps do not directly involve ownership of the actual asset, they serve many purposes in financial markets. One of their main goals is to manage risks. For example, airlines can use energy swaps to lock in fuel prices, which protects them from sharp increases in oil costs. 

Speculation 

Swaps are also used for speculation. Traders might buy or sell swaps to bet on the swap price of an asset, hoping to profit from its movement. While this adds liquidity to markets, it also increases the potential for large losses if markets move in the wrong direction. 

Arbitrage 

In some cases, swaps can be used for arbitrage. This involves taking advantage of price differences in different markets to earn a profit. A trader might buy an asset in one market and sell a swap tied to it in another, earning the difference with minimal risk—at least in theory. 

In short, swaps are central to how modern finance operates. They help stabilize prices, increase efficiency in markets, and provide tools for managing uncertainty. 

Upsides and downsides of swaps 

Swaps bring many advantages to financial systems, but they also come with notable dangers. Their impact depends on how and why they are used. Below are some benefits and risks that come with swaps: 

Upsides of swaps 

• Hedging against price changes: Swaps allow companies and investors to protect themselves from unfavorable price movements. A wheat farmer might use a swaps contract to lock in a sale price for their crop, protecting their income even if wheat prices fall. 
• Access to markets or strategies not available otherwise: With swaps, investors can take positions in markets where direct access is difficult or expensive. For example, some investors use index options to gain exposure to an entire stock market without owning every stock in it. 
• Lower capital requirements: Many swaps require only a small upfront payment known as a margin. This allows investors to control a larger position with less capital. While this increases potential returns, it also increases potential losses. 
• Price discovery: Because swaps markets often respond quickly to new information, they can help reveal what investors expect swap prices to be. This helps businesses and governments make informed decisions. 
• Liquidity: In many cases, swaps are highly liquid, especially those that are traded on regulated exchanges. This means they can be bought or sold quickly, often at a low cost. 

Downsides of swaps 

• Leverage can magnify losses: Because only a small amount of money is needed to control a large position, losses from swaps can be much larger than the original investment. For instance, in the 2008 financial crisis, some banks took too many risks. 
• Counterparty risk: In OTC swaps, there is always a chance the other party will fail to meet their obligations. If a major institution defaults, the ripple effects can be severe. 
• Market complexity: Swaps can be difficult to understand, especially for retail investors. This can lead to misuse or unexpected outcomes. For example, a person might think they are limiting risk when they are actually increasing it. 
• Lack of transparency: Some swaps are not traded on public exchanges, making it hard for regulators or even participants to see the full extent of exposure. This hidden risk can create systemic problems. 
• Legal and operational risks: Errors in contracts, miscommunication, or failure to properly manage and monitor positions can lead to financial loss. In fast-moving markets, even a minor oversight can have major consequences. 
• Correlation breakdown: Swaps often assume a relationship between two assets. If that relationship breaks down, the swap might not behave as expected. This risk increases during times of financial stress. 

Despite the risks, swaps remain a useful tool for managing financial exposure. The challenge lies in understanding how they work and using them wisely. Investors, companies, and regulators will continue to learn from past mistakes and improve safeguards. 

The goal is to keep the benefits of swaps while limiting the damage they can cause when misused. Overall, swaps might not be a fit for every client, but they can be a smart addition to the toolbox of a modern wealth advisor. 

Want to see more articles about swaps and other investment options? Keep browsing for more below.