A foreign exchange swap is a composite over the counter OTC foreign exchange transaction which involves:. The uses of FX swaps include the temporary transformation of short term borrowings or deposits from one currency into another. A closely related use of FX swaps is to concentrate temporary cash surpluses, to improve short-term investment income. 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. 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.
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. 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. 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. FX swaps should not be confused with interest rate swaps , nor cross-currency interest rate swaps , which are both different.
Powers of concentration - using FX swaps. A composite over the counter foreign exchange transaction.More...