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Foreign exchange swap

A forex swap (also referred to as an FX swap) is when one currency is simultaneously purchased and sold for the same amounts of another currency, with two different value dates (usually spot to forward).

Structure

A forex swap has two legs:
1. a spot foreign exchange transaction, and
2. a forward foreign exchange transaction.

These two legs are executed at the same time for the same quantity, and thus offset each other.

It is also common to trade forward-forward, where both transactions are for different forward dates.

Uses

FX swaps are most commonly used for institutions to fund their foreign exchange balances.

When 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. To collect or pay any overnight interest due on these foreign balances, at the end of every day businesses will close out any foreign balances and re-institute them for the next day. To do this they usually use tom-next swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back settling the day after.

The interest collected or paid every night is called the cost of carry. As currency traders know approximately 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 can be explained by this equation:

Here:
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:

where r1 and r2 are small. Therefore, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.

Related instruments

One should not mistake a forex swap with a currency swap, which is a much rarer, long term transaction, abiding to a slightly different set of rules.

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