Forex swap

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).; see Foreign exchange derivative.

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.

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 (selling) a foreign amount settling tomorrow, and selling (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:

:$F\; =\; S\; \backslash left(\; \backslash frac\{1+r\_1\}\{1+r\_2\}\backslash right)^T$

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:

:$F\; -\; S\; =\; S\; \backslash left[\; \backslash left(\backslash frac\{1+r\_1\}\{1+r\_2\}\backslash right)^T\; -1\; \backslash right]\; \backslash approx\; S\; \backslash left(\; e^\backslash left(\backslash left(r\_1\; -\; r\_2\backslash right)T\backslash right)\; -\; 1\backslash right)$

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

Currency swap

Overnight index swap

Foreign exchange market

Interest rate swap

CURRENCY SWAP: A transaction in which the bank agrees to exchange specified amount of one currency for another currency on future dates at a fixed price Cash flows can be exchanged for both principal and interest (cross-currency swap), interest only (coupon-only swap) and only principal (principal-only swap)

INTEREST RATE SWAP: A transaction in which the Bank contracts to exchange a fixed interest liability for a floating interest rate liability or vice versa on behalf of the client No exchange of principal amount, only difference in cash flows are settled Benchmark rates from NSE MIBOR, 1-year INBMK, 5 year INBMK rates are normally used

References

Category:Derivatives Category:Foreign exchange market Category:Interest rates