Forex swap
Encyclopedia
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).; see Foreign exchange derivative
.
These two legs are executed simultaneously for the same quantity, and therefore offset each other.
It is also common to trade forward-forward, where both transactions are for (different) forward dates.
Once 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. 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. To do this they typically 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 referred to as the cost of carry
. As currency traders know roughly 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
.
where:
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.
, which is a much rarer, long term transaction, governed by a slightly different set of rules.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, 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).; see Foreign exchange derivative
Foreign exchange derivative
A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. For detail see:...
.
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.
It is also common to trade forward-forward, where both transactions are for (different) forward dates.
Uses
By far and away the most common use of FX swaps is for institutions to fund their foreign exchange balances.Once 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. 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. To do this they typically 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 referred to as the cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
. As currency traders know roughly 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
Carry (investment)
The carry of an asset is the return obtained from holding it , or the cost of holding it .For instance, commodities are usually negative carry assets, as they incur storage costs or may suffer from depreciation, but in some circumstances, appropriately hedged commodities can be positive carry...
.
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 (calculated according to the appropriate day count conventionDay count conventionIn finance, a day count convention determines how interest accrues over time for a variety of investments, including bonds, notes, loans, mortgages, medium-term notes, swaps, and forward rate agreements . This determines the amount transferred on interest payment dates, and also the calculation of...
)
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.
Related instruments
A forex swap should not be confused with a currency swapCurrency swap
A currency swap is a foreign-exchange agreement between two parties to exchange aspects of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage...
, which is a much rarer, long term transaction, governed by a slightly different set of rules.