Explaining Swaps, or How to Hedge Currencies: QuickTake Q&A

It’s a huge business: Foreign exchange transactions using the tools of hedging amount to trillions of dollars a day and outstrip regular day-to-day currency trading. Hedging comes in as companies seek to protect overseas profits or minimize costs from swings in exchange rates. Investors, including central banks, speculators and hedge funds are also frequent users of the instruments. The most common methods are foreign-exchange swaps and the lesser used cross-currency basis swaps.

Demand for currency-hedging instruments has been indirectly spurred by central bank policies that have crushed interest rates in some of the biggest economies, the Bank for International Settlements said in 2016. As investors look abroad for higher yields and companies went to foreign markets to borrow cheaply, they need to hedge their exposure. For instance, Japanese life insurers have developed a penchant for FX-hedged investments in dollar-denominated bonds.