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 exchange of two different currencies
- on a specific 'near leg' date
- at a fixed foreign exchange rate which is pre-agreed at the outset of the contract; and
(B) A reverse exchange of the same two currencies
- on a later pre-specified 'far leg' date
- at a fixed exchange rate which is usually different and which is also pre-agreed at the outset of the contract.
Uses
The uses of FX swaps include the transformation of short term borrowings or deposits from one currency into another.
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, 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 price-taker 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 - is reflected in the 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.
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.
