Foreign exchange swap

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 month.

They could 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 EUR/GBP exchange rate moves against them, they may have to spend a lot more GBP to get the same amount of EUR.

Therefore they create a 1 month 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. The company knows they will be able to purchase EUR reliably while still being able to use currency for domestic transactions in the interim.

Pricing

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

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

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:

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

if ${\displaystyle r_f\cdot T}$ 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.