In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase
and sale of identical amounts of one currency for another with two different value dates.
see Foreign exchange derivative. Foreign Exchange Swap allows sums of a certain currency to
be used to fund charges designated in another currency without acquiring foreign exchange
risk. It permits companies that have funds in different currencies to manage them efficiently.
swap contract: swap contract is an agreement between two party to exchange a cash flow
in one currency against a cash flow in another currency according to predetermined terms
& conditions.
Structure A foreign exchange swap consists of two legs:
a spot foreign exchange transaction, and a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and therefore offset
each other. Forward foreign exchange transactions occur
if both companies have a currency the other needs. It prevents negative foreign exchange
risk for either party. Foreign exchange spot transactions are similar to forward foreign
exchange transactions in terms of how they are agreed upon; however, they are planned
for a specific date in the very near future, usually within the same week.
It is also common to trade forward-forward, where both transactions are for forward dates.
Uses The most common use of foreign exchange swaps
is for institutions to fund their foreign exchange balances.
Once a foreign exchange transaction settles, the holder is left with a positive position
in one currency, and a negative position in another. In order to collect or pay any overnight
interest due on these foreign balances, at the end of every day institutions will close
out any foreign balances and re-institute them for the following day. To do this they
typically use tom-next swaps, buying a foreign amount settling tomorrow, and then doing the
opposite, selling it back settling the day after.
The interest collected or paid every night is referred to as the cost of carry. As currency
traders know roughly how much holding a currency position will make or cost on a daily basis,
specific trades are put on based on this; these are referred to as carry trades.
Companies may also use them to avoid foreign exchange risk.
Example: A British Company may be long EUR from sales
in Europe but operate primarily in Britain using GBP. However, they know that they need
to pay their manufacturers in Europe in 1 months time.
They could of course SPOT Sell their EUR and buy GBP to cover their expenses in Britain,
and then in one month SPOT Buy EUR and sell GBP to pay their business partners in Europe.
However, this exposes them to FX risk. If Britain has financial trouble and the EURGBP
exchange rate goes against them, they may have to spend a lot more GBP to get the same
amount of EUR. Therefore they create a 1M Swap, where they
Sell EUR and Buy GBP on SPOT and simultaneously Buy EUR and Sell GBP on a 1 Month forward.
This significantly reduces their risk as they know that they will be able to purchase EUR
reliably, while still being able to use the money for their domestic transactions in the
meantime. Pricing
The relationship between spot and forward is known as the interest rate parity, which
states that
where F = forward rate
S = spot rate rd = simple interest rate of the term currency
rf = simple interest rate of the base currency T = tenor
The forward points or swap points are quoted as the difference between forward and spot,
F - S, and is expressed as the following:
if is small. Thus, the value of the swap points is roughly proportional to the interest rate
differential. Related instruments
A foreign exchange swap should not be confused with a currency swap, which is a much rarer,
long term transaction, governed by a slightly different set of rules.
See also Overnight indexed swap
Foreign exchange market Interest rate parity
Forward exchange rate Cross currency swap
References