Foreign exchange swap

(FX swap).

A composite over the counter foreign exchange transaction.

Definition of FX swaps

A foreign exchange swap is a composite over the counter (OTC) foreign exchange transaction which involves:

(A) An initial exchange of two different currencies

1. on a specified 'near leg' date
2. at a fixed foreign exchange rate which is pre-agreed at the outset of the contract; and

(B) A reverse-direction exchange of the same two currencies

1. on a later pre-specified 'far leg' date
2. at a fixed exchange rate which is usually different, and which is also pre-agreed at the outset of the contract.

Uses

1.

The uses of FX swaps include the temporary transformation of short term borrowings or deposits from one currency into another.

For example, if a customer has a temporary surplus of GBP and a shortfall of EUR for a week, it could enter into the following FX swap contract:

• Exchange the temporary surplus of GBP into EUR for value spot (the 'near leg')
• Re-exchange the EUR back into GBP, for value a week later (the 'far leg')

2.

A closely related use of FX swaps is to concentrate temporary cash surpluses, to improve short-term investment income.

3.

FX swaps are also used to modify the value date of an existing forward foreign exchange contract.

The combination of the FX swap and the existing forward contract, re-establishes the forward contract, with a later value date.

Amounts of currency

The amounts of currency in the far leg re-exchange are generally greater than those in the near leg, by the amount of interest payable or receivable in the currency which the customer is swapping into.

For example, when hedging a deposit with a swap, the far leg amount will usually be greater than the amount in the near leg, by the amount of interest receivable on the swapped deposit.

Similarly, when hedging a borrowing using a swap, the far leg amount will normally be greater, by the interest payable on the swapped borrowing.

As the FX swap is an OTC contract, the provider and the customer are free to tailor the amounts of currency to be exchanged in this way, to meet the customer's individual hedging requirements.

Another way of achieving this result is to use the same principal amount of currency in the near leg and the far leg, and to deal with interest in a separate outright forward transaction.

When the far leg rate of the swap is set equal to the outright forward foreign exchange rate - as is often the case in practice - the result achieved is economically identical to rolling up the entire composite deal within the swap.

Pricing

The composite pricing of the FX swap is favourable for the price-taker (customer), compared with the pricing of two related outright contracts, for example for spot exchange and forward re-exchange of the same currency pair.

The reason that the market maker can give a better price for the price-taker, is that the market maker is not taking any foreign exchange risk on the composite transaction.

The market-maker can hedge its position by a borrowing and a deposit in the two currencies being swapped.

The prices and cost for the customer therefore only reflect the bid-offer spreads on the hedging interest rate contracts.

The market maker does not need to strike any hedging foreign exchange contracts. This saving - of the spread on the hedging FX contract - can be reflected in favourable pricing for the customer.

FX swap viewed as simultaneous borrowing and deposit

An FX swap agreement can also be viewed as a simultaneous borrowing of one currency, and a lending of the other currency, with the same counterparty.

This is relatively low risk for the market maker, because it can be viewed as a secured/collateralised loan by the market maker, the collateral being the simultaneous deposit received from the customer.

For this reason the agreement can be priced relatively favourably for the customer, compared with a spot FX deal and a foreign exchange forward contract.

Interest rate swaps and cross-currency interest rate swaps

FX swaps should not be confused with interest rate swaps, nor cross-currency interest rate swaps, which are both different.

See also

• Bespoke
• Cash concentration
• Cross-currency interest rate swap
• Currency swap
• Foreign exchange
• Foreign exchange forward contract
• Interest rate swap
• Over the counter
• Spot
• Swap
• Swap points
• Spread

Student article

Powers of concentration - using FX swaps