Foreign exchange swap
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INTRODUCTION
In finance, a 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 (FX) swap is a monetary transaction whereby two parties exchange earlier decided amounts of two currencies as a spot transaction, and also agreeing to exchange at a future date, based on both interest and principal payments. When the one of the agent is a central bank, the motivation for undertaking the swap is usually either to affect domestic liquidity or to manage foreign exchange reserves so that the economy can be benefitted. Rarely, central banks have been known to use currency swaps for the main purpose of hedging and asset liability .It dimnishes the expected exchange losses arising due to opposing exchange rate movements when your foreign currency payables and receivables are at different dates.
FX swaps are used to obtain foreign currencies, both for financial institutions and their customers, including exporters and importers. FX swaps are most liquid when bought at terms shorter than one year, but transactions with longer maturities have been increasing in recent years . Forex swaps combined with some interest rate swaps. For example, 1 company would seek to swap their asset for a fixed rate in US$ denomination for a floating-rate debt that is denominated in Euro. The financial swaps are particularly common in parts of Europe where organizations shop for the least expensive debt regardless of its type of denomination and then seek to swap it for the debt in their desired currency.
Structure
A forex 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.
It is also common to trade forward-forward, where both transactions are for (different) forward dates.
There are various features of forex swaps which are as follows
- there is a free open arrangement
- helps have a better usage of companies liquidity
- it is also an excellent planning tool
- it also helps eliminate risks of possible exchange losses resulting from forex cash flow mismatches and fluctuating forex rates
- spot rate for the purchase and sale of forex swaps is set simultaneously
- there is a broad range of currencies.
However according to Indian Finance Minister Mr. Chidambaram says Forex Swaps are risky for Indian markets
Uses
By far and away the most common use of FX 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.
Pricing
The relationship between spot and forward is as follows:
where:
- F = forward rate
- S = spot rate
- r1 = simple interest rate of the term currency
- r2 = 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:
where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.
Related instruments
A forex 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
References
- ^ Reuters Glossary http://glossary.reuters.com/index.php?title=FX_Swap.