I didn’t know enough about FX swaps to comment personally, but Investopedia says this:
The top risk with foreign currency swaps is currency risk. Currency risk arises from fluctuations in exchange rates between two currencies involved in the swap. When companies or financial institutions enter into a swap, they agree to exchange cash flows in different currencies at future dates. If/when the exchange rate moves, one party may end up paying significantly more in its domestic currency than anticipated. For example, if a company swaps U.S. dollars for euros and the euro strengthens, the company will need to pay more in dollars to meet its euro obligations.
Another key risk is interest rate risk. Foreign currency swaps often involve exchanging fixed or floating interest payments on the notional amounts of the two currencies. If interest rates in one country rise unexpectedly, the party receiving fixed interest payments in that currency may miss out on higher interest income. If interest rates decline, the party paying floating rates could face higher-than-expected costs.
Counterparty risk is another risk. In any swap agreement, the parties involved rely on each other to fulfill their obligations. If one party defaults, the other party may face financial losses. To mitigate this risk, companies often perform thorough due diligence on their counterparties or utilize clearinghouses for swap agreements. As is the case with most financial instruments, this risk cannot be eliminated.
Last, the liquidity risk associated with foreign currency swaps is another factor to consider. These swaps typically have long maturities, and the liquidity of certain currencies can fluctuate over time. If market conditions change and a party wants to exit the swap early, they may find it difficult to find a willing counterparty, especially if they wish to trade or exchange out of their position.
Company A sells widgets for dollars made from raw materials bought in yen.
Company B sells woggles for yen made from raw materials bought in dollars.
Both companies can reduce their risk by agreeing to exchange yen for dollars at an agreed fixed value. No one is gambling. Everyone is reducing their risk.
Interest rates, some companies may have floating income they wish to swap for long term fixed, and others may have too much long term debt which has a volatile mtm value.
Counterparty risk, usually mitigated by diversification. Companies pool their specific risk for a lower, but more certain, general risk (and use clearing houses).
Liquidity risk. Only a problem if you need to sell something quickly. Here there are gamblers taking advantage. There’s no-one that naturally wants to take the other side of illiquid assets.
In isolation. But let’s look at insurance, to the consumer it’s the opposite of gambling. Gambling is seeking excitement through financial risk, but insurance is accepting that all of life is risky and that you’d rather pay a flat rate every month not to bother with the risk. But to the insurance company it’s not like they’re just holding and waiting, no they’re firstly pooling enough people to attempt to make payouts as stable as possible. Your house burning down is one of the worst days of your life, but it’s just another day at work to the fire department and insurance company, they see that sort of thing regularly. Additionally they hire actuaries and statisticians to minimize their risks and to make sure they aren’t charging people little enough they go under if they have a bad week or month. It’s why you can’t buy house insurance in Florida anymore, they’ve accepted that climate change has resulted in too much volatility in that area and that they wouldn’t be able to get people to pay the cost necessary to sufficiently hold that risk.
Firstly, insurance isn’t a derivative, so it’s not really relevant here.
Secondly, paying insurance is still a form of financial risk. If you pay insurance for the entire time you own a home, but never file a claim, then that’s basically just money wasted. You’re trading material risk to your home for financial risk.
And it’s also basically a gamble. You’re betting that the total you pay in premiums will be less than whatever the insurance company will pay you. The insurance company is betting that it’ll be higher.
Every transaction has a counter-party. Reduced risk on one side increases risk on the other.
Not necessarily. Two companies in different countries can both reduce their risk by entering into an FX swap.
I didn’t know enough about FX swaps to comment personally, but Investopedia says this:
Company A sells widgets for dollars made from raw materials bought in yen.
Company B sells woggles for yen made from raw materials bought in dollars.
Both companies can reduce their risk by agreeing to exchange yen for dollars at an agreed fixed value. No one is gambling. Everyone is reducing their risk.
Interest rates, some companies may have floating income they wish to swap for long term fixed, and others may have too much long term debt which has a volatile mtm value.
Counterparty risk, usually mitigated by diversification. Companies pool their specific risk for a lower, but more certain, general risk (and use clearing houses).
Liquidity risk. Only a problem if you need to sell something quickly. Here there are gamblers taking advantage. There’s no-one that naturally wants to take the other side of illiquid assets.
In isolation. But let’s look at insurance, to the consumer it’s the opposite of gambling. Gambling is seeking excitement through financial risk, but insurance is accepting that all of life is risky and that you’d rather pay a flat rate every month not to bother with the risk. But to the insurance company it’s not like they’re just holding and waiting, no they’re firstly pooling enough people to attempt to make payouts as stable as possible. Your house burning down is one of the worst days of your life, but it’s just another day at work to the fire department and insurance company, they see that sort of thing regularly. Additionally they hire actuaries and statisticians to minimize their risks and to make sure they aren’t charging people little enough they go under if they have a bad week or month. It’s why you can’t buy house insurance in Florida anymore, they’ve accepted that climate change has resulted in too much volatility in that area and that they wouldn’t be able to get people to pay the cost necessary to sufficiently hold that risk.
Firstly, insurance isn’t a derivative, so it’s not really relevant here.
Secondly, paying insurance is still a form of financial risk. If you pay insurance for the entire time you own a home, but never file a claim, then that’s basically just money wasted. You’re trading material risk to your home for financial risk.
And it’s also basically a gamble. You’re betting that the total you pay in premiums will be less than whatever the insurance company will pay you. The insurance company is betting that it’ll be higher.