 Hey guys, it's MJ the students Actory and this is subject CT2 chapter 5 and in this audio track We're gonna be talking about the swap contract and before we get into what a swap is I just want to bring you back to your childhood days When you may have been in the playground and we've got your Pokemon cards You've got a Pokemon card that your friend has and your friend has a Pokemon card that you have What would then happen is the two of you would then agree to exchange the Pokemon cards and it will be beneficial for both parties For example, if I've got a deck of water Pokemon I might trade my fire Charizard for your blast toys Which is a water Pokemon because it makes better sense for my deck Now the same goes when it comes to the financial markets Instead of dealing with Pokemons though, we're dealing with various cash flows So one way of thinking of a swap is saying that a swap is a contract between two parties under which they agree to exchange a series of payments according to a pre-arranged formula and There are various types of swaps you can do But let's focus in on a currency exchange swap just to get the general idea Let's say I have a company that makes shoes and I'm selling them on the American market, so I'm getting dollars But I'm paying my workers in rands and all my other expenses on rands So now there is a mismatch between the currencies. I'm earning dollars But I'm paying out in rands Whereas there could be another company that has the opposite situation they could be an American company which are selling let's say, I don't know iPhones to South Africa and They're earning money in rands, but they're paying their employees in dollars Now for both of these companies they have exposure to the currency markets and As we've seen I mean you just have to turn on the daily news and they've always shown you how the exchange rates of various Currencies are fluctuating one day the dollar strengthens against the rent the other day the rent strengthens against the dollar Although recently the rent has been obliterated by the dollar, but let's assume that they they fluctuate Sometimes it goes up. Sometimes it goes down What we can do is these two parties can get in contact with each other and both can gain by swapping their cash flows So I could make a deal with this iPhone company and say for every dollar I get I will exchange it for 15 rand and What in effect we're doing is we're locking in the exchange rate This way if the dollar strengthens to the rand I'm not exposed to that currency Fluctuation which is where I want to be my business is focusing on selling shoes I want to make money because I make a good shoe. I want to lose money if I don't make a good shoe I don't want my profit to be dependent on currency fluctuations, which I have no control over and So this is what we're doing if the dollar strengthens I'm losing out because I've already locked in 15 and to one dollar but if the dollar devalues I gain because we've locked it in and What we've done is we're swapping rands for dollars Dollars for rents depending on which side you look at it and by doing so we've eliminated currency risk Now these other types of swaps what we could have is sometimes you could have a financial instrument that pays a fixed interest rate and Another person could have another financial instrument that pays variable interest rates And then what these two parties can do is they can agree to swap them Where the maths or the whole logistics gets a little bit complicated is sometimes we have a middleman or an exchange or a clearing House and what they do is they actually are the person that engages with you So instead of me dealing with the iPhone company I deal with the clearing house and they make a swap with me They then go and they also do another swap with the iPhone company so their total position is They've got no exposure whatsoever to either of the currencies and they're making their money as an admin fee Because they are connecting people although what we're seeing We'll kind of think of it as as like being on the playground instead of trying to find someone to trade Your fire Pokemon for their water Pokemon Imagine if the school had a system where no matter what if you trade in your your Pokemon, they'll trade it with you for a small fee This has been happening for for quite a while But we may be seeing a fundamental shift in the way this is done as Peer-to-peer networks are developing and the internet has shown that it can connect people Without the need for a centralized party We could see swaps in the future being arranged very differently kind of on a blockchain system Which Bitcoin uses but you don't have to worry too much about that because that won't be in the exam Well won't be in the exam for the next three years I'm assuming that the actuarial profession will update the course material Once the new technology has fed in and then it will be in your exam. So if you're listening to this in like 2019 then yeah, you probably know all about the blockchain and all that type of stuff But that is what a swap contract is it's exchanging series of payments according to a pre-arranged formula and We've shown how it can yeah reduce your currency risk And if you had interest rates it can reduce your interest rates risks But that's all we got time for I'm gonna be stopping this otherwise These videos gone too much. I might make another one on chapter five or I might move on to chapter six But yeah, I'll let you guys know. Cheers