Foreign exchange swap

Not to be confused with Currency swap.

Foreign exchange
Exchange rates
Currency band Exchange rate Exchange-rate regime Exchange-rate flexibility Dollarization Fixed exchange rate Floating exchange rate Linked exchange rate Managed float regime
Markets
Foreign exchange market Futures exchange Retail foreign exchange
Assets
Currency Currency future Currency forward Non-deliverable forward Foreign exchange swap Currency swap Foreign exchange option
Historical agreements
Bretton Woods Conference Smithsonian Agreement Plaza Accord Louvre Accord
See also
Bureau de change Hard currency Currency pair

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 (normally spot to forward).^[1] 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.^[2] swap contract: swap contract is an agreement between two parties to exchange a cash flow in one currency against a cash flow in another currency according to predetermined terms and conditions.

Structure

A foreign exchange swap has two legs—a spot transaction and a forward transaction—that 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.^[3] 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 (different) 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 (or "long") position in one currency, and a negative (or "short") 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 (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) 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 (1M) 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

Main article: Interest rate parity

The relationship between spot and forward is known as the interest rate parity, which states that

F = S \left( \frac{1+r_d T}{1+r_f T}\right) ,

where

F = forward rate
S = spot rate
r_d = simple interest rate of the term currency
r_f = simple interest rate of the base currency
T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

F - S = S \left( \frac{1+r_d T}{1+r_f T} -1 \right) = \frac{S (r_d - r_f) T}{1+r_f T} \approx S \left( r_d - r_f \right) T ,

if $r_f T$ 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 rarer long-term transaction governed by different rules.

References

Derivatives market

Derivative (finance)

Options

Terms	Credit spread Debit spread Exercise Expiration Moneyness Open interest Pin risk Risk-free interest rate Strike price the Greeks Volatility

Vanilla options	Bond option Call Employee stock option Fixed income FX Option styles Put Warrants

Exotic options	Asian Barrier Basket Binary Chooser Cliquet Commodore Compound Forward start Interest rate Lookback Mountain range Rainbow Swaption

Combinations	Collar Fence Iron butterfly Iron condor Straddle Strangle Covered call Married put Risk reversal

Spreads	Back Bear Box Bull Butterfly Calendar Diagonal Intermarket Ratio Vertical

Valuation	Binomial Black Black–Scholes model Finite difference Garman-Kohlhagen Margrabe's formula Put–call parity Simulation Real options valuation Trinomial Vanna–Volga pricing

Swaps

Exotic derivatives

Other derivatives

Market issues

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