Main Instruments: Over-the-Counter Market – FX SWAPS

Main Instruments: Over-the-Counter Market - FX SWAPS

In the spot and outright forward markets, one currency is traded outright for another, but in the FX swap market, one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange.

3. FX SWAPS

In the spot and outright forward markets, one currency is traded outright for another, but in the FX swap market, one currency is swapped for another for a period of time, and then swapped back, creating an exchange and re-exchange.

An FX swap has two separate legs settling on two different value dates, even though it is
arranged as a single transaction and is recorded in the turnover statistics as a single transaction. The two counterparties agree to exchange two currencies at a particular rate on one date (the “near date”) and to reverse payments, almost always at a different rate, on a specified subsequent date (the “far date”).Effectively, it is a spot transaction and an outright forward transaction going in opposite directions, or else two outright forwards with different settlement dates,and going in opposite directions. If both dates are less than one month from the deal date, it is a “short-dated swap”; if one or both dates are one month or more from the deal date, it is a “forward swap.”

The two legs of an FX swap can, in principle, be attached to any pair of value dates. In practice, a limited number of standard maturities account for most transactions. The
first leg usually occurs on the spot value date, and for about two-thirds of all FX swaps the second leg occurs within a week.However, there are FX swaps with longer maturities. Among dealers, most of these are arranged for even or straight dates—e.g., one week, one month, three months—but odd or broken dates are also traded for customers.

The FX swap is a standard instrument that has long been traded in the over-the-counter market. Note that it provides for one exchange and one reexchange only, and is not a stream of payments. The FX swap thus differs from the interest rate swap, which provides for an exchange of a stream of interest payments in the same currency but
with no exchange of principal; it also differs from the currency swap (described later), in
which counterparties exchange and re-exchange principal and streams of fixed or floating interest payments in two different currencies.

In the spot and outright forward markets, a fixed amount of the base currency (most often
the dollar) is always traded for a variable amount of the terms currency (most often a
non-dollar currency). However, in the FX swap market, a trade for a fixed amount of either
currency can be arranged.

There are two kinds of FX swaps: a buy/sell swap, which means buying the fixed, or base, currency on the near date and selling it on the far date; and a sell/buy swap, which means selling the fixed currency on the near date and buying it on the far date. If, for example, a trader bought a fixed amount of pounds sterling spot for dollars (the
exchange) and sold those pounds sterling six months forward for dollars (the re-exchange), that would be called a buy/sell sterling swap.

  • Why FX Swaps Are Used
    The popularity of FX swaps reflects the fact that banks and others in the dealer, or interbank, market often find it useful to shift temporarily into or out of one currency in exchange for a second currency without incurring the exchange rate risk of holding an open position or exposure in the currency that is temporarily held. This avoids a change in currency exposure, and differs from the spot or outright forward, where the purpose is to change a currency exposure. The use of FX swaps is similar to actual borrowing and lending of currencies on a collateralized basis. FX swaps provide a way of using the foreign exchange markets as a funding instrument and an alternative to borrowing and lending in the Eurodollar
    and other offshore markets.They are widely used by traders and other market participants for managing liquidity and shifting delivery dates, for hedging, speculation, taking positions on interest rates, and other purposes.
  • Pricing FX Swaps
    The cost of an FX swap is determined by the interest rate differential between the two swapped currencies. Just as in the case of outright forwards, arbitrage and the principle of covered interest rate parity will operate to make the cost of an FX swap equal to the foreign exchange value of the interest rate differential between the two currencies for the period of the swap.

The cost of an FX swap is measured by swap points, or the foreign exchange equivalent
of the interest rate differential between two currencies for the period. The difference
between the amounts of interest that can be earned on the two currencies during the period of the swap can be calculated by formula (see Box 5-4). The counterparty who holds for the period of the swap the currency that pays the higher interest rate will pay the points, neutralizing the interest rate differential and equalizing the return on the two currencies; and the counterparty who holds the currency that pays the lower interest will earn or receive the points.At the outset, the present value of the FX swap contract is usually arranged to be zero.

The same conditions prevail with an FX swap as with an outright forward—a trader who pays the points in the forward also pays them in the FX swap; a trader who earns the points in the forward also earns them in the FX swap.

For most currencies, swap points are carried to the fourth decimal place. A dollar-swissie swap quoted at 244-221 means that the dealer will buy the dollar forward at his spot bid rate less 0.0244 (in Swiss francs), and sell the dollar forward at his spot offer rate less 0.0221 (in Swiss francs), yielding an (additional) spread of 23 points (or 0.0023).

The FX swap is the difference between the spot and the outright forward (or the difference between the two outright forwards).When you trade an FX swap you are trading the interest rate differential between the two currencies. The FX swap is a very flexible and convenient instrument that is used for a variety of funding, hedging, position management, speculation, and other purposes. FX swaps are extremely popular among OTC interbank dealers, and now account for nearly half of total turnover in the U.S. OTC foreign exchange market. Among its uses are those described in Box 5-3:

Box 5.3

[NP][/NP]

Box 5.4

[NP][/NP]

This article has been reprinted with the authorization of the Federal Reserve