What Is Swap in Forex Trading
What is a Foreign Exchange Swap?
A foreign exchange swap (also known as an FX swap) is an agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity. It is useful for risk-free lending, as the swapped amounts are used as collateral Collateral Collateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. for repayment.
Summary
- A foreign exchange swap refers to an agreement to simultaneously borrow one currency and lend another currency at an initial date, then exchanging the amounts at maturity.
- Leg 1 is the transaction at the prevailing spot rate. Leg 2 is the transaction at the predetermined forward rate.
- Short-dated foreign exchange swaps include overnight, tom-next, spot-next and spot-week
- Foreign exchange swaps and cross currency swaps differ in interest payments.
Understanding Foreign Exchange Swaps
For a foreign exchange swap to work, both parties must own a currency and need the currency that the counterparty owns. There are two "legs":
Leg 1 at the Initial Date
The first leg is a transaction at the prevailing spot rate. The parties swap amounts of the same value in their respective currencies at the spot rate. The spot rate is the exchange rate at the initial date.
Leg 2 at Maturity
The second leg is a transaction at the predetermined forward rate at maturity. The parties swap amounts again, so that each party receives the currency they loaned and returns the currency they borrowed.
The forward rate is the exchange rate on a future transaction, determined between the parties, and is usually based on the expectations of the relative appreciation/depreciation of the currencies. Expectations stem from the interest rates offered by the currencies, as demonstrated in the interest rate parity. If currency A offers a higher interest rate, it is to compensate for expected depreciation against currency B and vice versa.
Foreign exchange swaps are useful for borrowing/lending amounts without taking out a cross-border loan Cross-Border Financing Cross-border financing is the process of sourcing funds from outside the home country's border. It is useful for multinational businesses to . It also eliminates foreign exchange risk by locking in the forward rate, making the future payment known.
Practical Example
Party A is Canadian and needs EUR. Party B is European and needs CAD. The parties enter into a foreign exchange swap today with a maturity of six months. They agree to swap 1,000,000 EUR, or equivalently 1,500,000 CAD at the spot rate of 1.5 EUR/CAD. They also agree on a forward rate of 1.6 EUR/CAD because they expect the Canadian Dollar to depreciate relative to the Euro.
Today, Party A receives 1,000,000 Euros and gives 1,500,000 Canadian Dollars to Party B. In six months' time, Party A returns 1,000,000 EUR and receives (1,000,000 EUR * 1.6 EUR/CAD = 1,600,000 CAD) from Party B, ending the foreign exchange swap.
Short-Dated Foreign Exchange Swap
Short-dated foreign exchange swaps refer to those with a maturity of up to one month. The FX market uses different shorthands for short-dated FX swaps, including:
- Overnight (O/N) – A swap today against tomorrow
- Tom-Next (T/N) – A swap tomorrow against the next day
- Spot-Next (S/N) – A swap starting spot (T+2) against the next day
- Spot-Week (S/W) – A swap starting spot against a week later
Foreign Exchange Swap vs. Cross Currency Swap
Foreign exchange swaps and cross currency swaps are very similar and are often mistaken as synonyms.
The major difference between the two is interest payments. In a cross currency swap, both parties must pay periodic interest payments in the currency they are borrowing. Unlike a foreign exchange swap where the parties own the amount they are swapping, cross currency swap parties are lending the amount from their domestic bank and then swapping the loans.
Therefore, while foreign exchange swaps are riskless because the swapped amount acts as collateral for repayment, cross currency swaps are slightly riskier. There is default risk Default Risk Default risk, also called default probability, is the probability that a borrower fails to make full and timely payments of principal and interest, in the event the counterparty does not meet the interest payments or lump sum payment at maturity, meaning the party cannot pay their loan.
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- Currency Risk Currency Risk Currency risk, or exchange rate risk, refers to the exposure faced by investors or companies that operate across different countries, in regard to unpredictable gains or losses due to changes in the value of one currency in relation to another currency.
- Fixed vs. Pegged Exchange Rates Fixed vs. Pegged Exchange Rates Foreign currency exchange rates measure one currency's strength relative to another. The strength of a currency depends on a number of factors such as its inflation rate, prevailing interest rates in its home country, or the stability of the government, to name a few.
- Forward Rate Forward Rate The forward rate, in simple terms, is the calculated expectation of the yield on a bond that, theoretically, will occur in the immediate future, usually a few months (or even a few years) from the time of calculation. The consideration of the forward rate is almost exclusively used when talking about the purchase of Treasury bills
- Interest Rate Parity (IRP) Interest Rate Parity (IRP) The interest rate parity (IRP) is a theory regarding the relationship between the spot exchange rate and the expected spot rate or forward exchange rate of two currencies, based on interest rates. The theory holds that the forward exchange rate should be equal to the spot currency exchange rate times the interest rate of the home country, divided by the interest rate of the foreign country.
Source: https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/foreign-currency-swap/
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