(upbeat music)
Foreign exchange or FX swaps are designed
to help manage timing mismatches, through the simultaneous
buying of one currency in the spot market
and selling of the same currency at a date in the future.
Timing mismatches result when transactions
in a foreign currency impact cash flows
in different time periods.
The net currency exposure
over the course of all the cash flows may be zero.
However, the ad hoc timing of receipts and payments
can still lead to an exposure
that can be eliminated through the FX swaps.
To remove the timing mismatches,
FX swaps are used to effectively
move transactions between time periods.
This offsets an actual cashflow transaction in one period
and moves it to another period where it can be much
to offset another exposure.
There are two key assumptions underlying the ability
to remove timing mismatches.
Firstly, the organisation is able to enter transactions
to sell or buy foreign currency as required.
And secondly, the organisation has the ability to borrow
to cover shortfalls or invest surplus proceeds as required.
Let us look at an example.
Consider an Australian organisation
that has regular exposures to the New Zealand dollar,
over the next six months.
In March, it receives 5 million New Zealand dollars,
and in June it pays 5 million New Zealand dollars.
The total net New Zealand dollar position is nil.
We can see that the net New Zealand dollar exposure
for the whole period is zero.
However, we can see that there are still timing mismatches
between the relevant receipts and payments
of the foreign currency.
Assume the organisation didn't have
a New Zealand dollar bank account.
The organisation would need to convert the
New Zealand dollar to Australian dollar in March,
and then convert the Australian dollar
back to the New Zealand dollar in June,
in order to make the June payment.
And so it will be exposed to currency movements
during that period.
The organisation could enter into an FX swap,
to remove the timing mismatches by moving
all the New Zealand dollar exposures to a single period,
such as March.
Assume this spot rate in March is 1.1111
and the June forward rate is 1.087.
The organisation would enter into an FX swap
to sell 5 million New Zealand dollars
in March at this spot rate of 1.1111
and buy 5 million New Zealand dollars in June,
at the forward rate of 1.087
The sell of 5 million New Zealand dollars in March,
offsets the initial receipts of New Zealand dollars
and delivers 4.5 million Australian dollars calculated
as 5 million New Zealand dollars divided by 1.1111.
The Australian dollars received, can be invested
until required in June to buy back the New Zealand dollar
at the locked in forward rate of 1.087.
The purchase of 5 million New Zealand dollars in June,
is used to make the plan payment of New Zealand dollars
and requires 4.6 million Australian dollars
calculated as 5 million New Zealand dollars
divided by 1.087.
As can be noted from the table,
the net New Zealand dollar position is nil,
as the receipt of the 5 million New Zealand dollars
is offset by the FX swap which sells
the 5 million New Zealand dollars in March
at this spot rate.
This results in a net cash position
of 4.5 million Australian dollars.
In June, the payment of 5 million New Zealand dollars
is again offset
by the purchase of 5 million New Zealand dollars
as part of the swap.
This results in a nil New Zealand dollar position.
It also results in a net Australian dollar
cash outflow position of 4.6 million,
which is used to make the June, New Zealand dollar payment,
upon conversion using the June forward rate.
This cash flow show that the swap results in netting
of the New Zealand dollar flows to zero
in both March and June removing the timing mismatch.
The Australian dollar differential is largely offset
by the receipt of the interest from investing
the Australian dollar proceeds during the June quarter.
To recap, FX swaps can be used
to eliminate timing mismatches
by buying of one currency in the spot market
and selling of the same currency at a date in the future.
They enable the cash flows
and currencies to be shifted to a specified period
in order to eliminate the foreign exchange exposures.