In finance, a foreign exchange swap, forexswap, or FX swap is a simultaneous purchase and sale of identical amounts of one currencyfor another with two different value dates.
see Foreign exchange derivative.
Foreign ExchangeSwap allows sums of a certain currency to be used to fund charges designated in anothercurrency without acquiring foreign exchange risk.
It permits companies that have fundsin different currencies to manage them efficiently.
swap contract: swap contract is an agreementbetween two party to exchange a cash flow in one currency against a cash flow in anothercurrency according to predetermined terms & conditions.
StructureA foreign exchange swap consists of two legs: a spot foreign exchange transaction, anda forward foreign exchange transaction.
These two legs are executed simultaneouslyfor the same quantity, and therefore offset each other.
Forward foreign exchange transactions occur if both companies have a currency the otherneeds.
It prevents negative foreign exchange risk for either party.
Foreign exchange spottransactions are similar to forward foreign exchange transactions in terms of how theyare 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.
UsesThe most common use of foreign exchange swaps is for institutions to fund their foreignexchange balances.
Once a foreign exchange transaction settles,the holder is left with a positive position in one currency, and a negative position inanother.
In order to collect or pay any overnight interest due on these foreign balances, atthe end of every day institutions will close out any foreign balances and re-institutethem for the following day.
To do this they typically use tom-next swaps, buying a foreignamount settling tomorrow, and then doing the opposite, selling it back settling the dayafter.
The interest collected or paid every nightis referred to as the cost of carry.
As currency traders know roughly how much holding a currencyposition 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 foreignexchange risk.
Example:A British Company may be long EUR from sales in Europe but operate primarily in Britainusing GBP.
However, they know that they need to pay their manufacturers in Europe in 1months time.
They could of course SPOT Sell their EUR andbuy GBP to cover their expenses in Britain, and then in one month SPOT Buy EUR and sellGBP to pay their business partners in Europe.
However, this exposes them to FX risk.
IfBritain has financial trouble and the EURGBP exchange rate goes against them, they mayhave 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 simultaneouslyBuy EUR and Sell GBP on a 1 Month forward.
This significantly reduces their risk as theyknow that they will be able to purchase EUR reliably, while still being able to use themoney for their domestic transactions in the meantime.
Pricing The relationship between spot and forwardis known as the interest rate parity, which states that whereF = forward rate S = spot raterd = simple interest rate of the term currency rf = simple interest rate of the base currencyT = tenor The forward points or swap points are quotedas the difference between forward and spot, F – S, and is expressed as the following: if is small.
Thus, the value of the swap pointsis roughly proportional to the interest rate differential.
Related instruments A foreign exchange swap should not be confusedwith a currency swap, which is a much rarer, long term transaction, governed by a slightlydifferent set of rules.
See alsoOvernight indexed swap Foreign exchange marketInterest rate parity Forward exchange rateCross currency swap References.