A Forex swap is a type of foreign exchange swap consisting of two parts, completed at the same time. One part is a foreign exchange spot trade, and the other is a foreign exchange forward transaction. Forex swaps are most often used by investors for either hedging or speculation purposes.
In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).
Structure
A forex swap consists of two legs:
- a spot foreign exchange transaction, and
- a forward foreign exchange transaction.
These two legs are executed simultaneously for the same quantity, and therefore offset each other.
Uses
By far and away the most common use of Forex 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.
Pricing
The relationship between spot and forward is as follows:
where:
- F = forward rate
- S = spot rate
- r1 = simple interest rate of the term currency
- r2 = simple interest rate of the base currency
- T = tenor
The forward points or swap points are quoted as the difference between forward and spot, F – S, and is expressed as the following:
where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa