In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates and may use foreign exchange derivatives. An FX swap allows sums of a certain currency to be used to fund charges designated in another currency without acquiring foreign exchange risk. It permits companies that have funds in different currencies to manage them efficiently.
Structure
A foreign exchange swap has two legs - a spot transaction and a forward transaction - that are executed simultaneously for the same quantity, and therefore offset each other. Forward foreign exchange transactions occur if both companies have a currency the other needs. It prevents negative foreign exchange risk for either party. Foreign exchange spot transactions are similar to forward foreign exchange transactions in terms of how they are 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.
Uses
The most common use of foreign exchange swaps is for institutions to fund their foreign exchange balances. Once a foreign exchange transaction settles, the holder is left with a positive position in one currency and a negative 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 a foreign amount settling tomorrow, and then doing the opposite, selling 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. Companies may also use them to avoid foreign exchange risk. Example:
Pricing
The relationship between spot and forward is known as the interest rate parity, which states that where
The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following: if is small. Thus, the value of the swap points is roughly proportional to the interest rate differential.
