ABSTRACT
This chapter explores the mysterious popularity of the swap contract. Banks themselves commonly effect swap transactions due to a currency mismatch between their customers' deposits and their loan portfolios. An inventory of swaps is usually considerably less volatile in value than an inventory of spot currency, under a freely floating exchange rate regime. The low volatility of the swap rate means that banks set higher maximum limits for their holdings of swap inventory than of spot inventory. The swap market is characterised by a higher degree of independent market-making and a lower degree of brokerage activity than is the spot market. Bid-offer spreads in the swap market increase with maturity as dealers protect themselves against increasing risk and have to cover an increasing expense of interbank and brokerage activity. Non-bank activity in the swap markets is not restricted to the hedge-operations. Where the swap margin itself shorn significant volatility, speculative trading interest may become important in the swap market.
