A currency swap or currency swap is a two-legged transaction that forex traders and other market participants use to change the value date of a currency position to another date that is usually farther in the future. . The term forex swap can also sometimes refer to pips or swap points that currency traders use when pricing a forex swap transaction.
Compare this definition of the jargon term commonly used by forex traders with the type of currency swap used by forex traders and their clients. This very different type of swap is a derivative contract between two counterparties to swap or exchange the interest payments on a loan in one currency for the interest payments on a loan in a different currency.
This article will focus on the type of swap that forex traders typically use, so read on to learn more about how FX swaps work and additional useful information about them than those who are already engaged in forex trading or who learn to trade forex might need to know.
How does an FX swap work?
In general, foreign exchange swaps involve the simultaneous buying and selling of a particular currency pair for different value dates, where a value date is the date on which the two currencies in a pair will actually be delivered to their respective counterparties. The amount of one currency in the pair is generally the same for both value dates, while the amount of the other currency differs if the quoted swap points are not zero.
To calculate the new forward exchange rate using the swap points quoted by forward traders, you need to add or subtract the indicated number of swap points from the exchange rate for the original value date of the transaction. The original value date is often the spot rate, but it can also be another value date, and an existing currency position can be rolled over.
Forex swaps are used by many currency market participants who need to establish a position for a forward value date. Many companies, fund managers, and long-term traders use currency swaps after initially making a trade in the spot market instead of just using daily rollovers, which is also a type of currency swap.
Daily rollovers are usually made by traders who execute positions overnight. Once 5:00 p.m. New York time has passed and a new trading day has begun, traders should perform a tom/next trade to retain the value of their currency position and avoid going through the process of delivery. Such a swap changes tomorrow’s value date (tom) to the next value date, which is usually the spot value or two business days from the present day for most currency pairs.
What is the process of an FX swap?
A currency swap is usually between two counterparties who own or can deliver different currencies. For example, the two sides of a possible swap transaction could be:
The first stage takes place on the original date of the swap transaction, usually at the prevailing spot rate. The parties will swap or exchange their respective currencies in equivalent amounts considering that particular spot rate.
Leg 2 takes place on the maturity date of the swap at the forward exchange rate. This process involves a second exchange of the agreed currency amounts taking into account any forward swap points that depend on the interest rate differential between the two currencies. The direction of this currency trade is the reverse of the initial trade made in Leg 1.
What are the types of swaps?
While all FX swaps involve exchanging one value date for another for a position in a currency pair, some commonly performed FX swaps have special names. A list of common short-term foreign exchange swaps includes:
- Overnight exchange: An exchange of today’s date for tomorrow’s value date.
- Tom-Next Swap (T/N): A trade between tomorrow’s value date and the next business day.
- Spot-Next (S/N) Exchange: A swap commencing on the spot value date against the next business day.
- Spot-Week Exchange (S/W): A swap beginning on the spot value date for a week later.
The tom-next swap is perhaps the best known of these specially named swap transactions, as traders who hold positions overnight typically perform this swap when they roll after 5 p.m. New York time. Most online forex brokers automatically make this exchange for their clients to retain the value of their trading position.
What is the difference between an FX Forward and an FX Swap?
A forward foreign exchange contract, also sometimes called a currency forward transaction, is a one-legged transaction executed for a forward value date that differs from the current spot value date. In contrast, a currency swap is a two-legged transaction that swaps a currency position from one value date to another that is usually further in the future.
It is common practice among forex market participants to execute futures contracts by first performing a spot trade and then performing a currency swap to exchange the spot position at the desired value date. This process allows a trader to quickly hedge their more volatile spot market risk and then roll out the position to a future value date at a more leisurely pace using the much more stable swap points quoted by futures traders on forex.
Example of a currency swap
Let’s take an example where an American company needs 10 million euros to pay for a contractual purchase which will be consumed three months later. To quickly hedge his currency risk from anticipated market volatility, he has already purchased the necessary euros with US dollars at a spot EUR/USD exchange rate of 1.0200.
This transaction will be delivered in two working days instead of three months when the euros are really needed. The company thus obtains a quote for a EUR/USD currency swap of +1 pip or +0.0001 from the same financial institution with which it carried out the initial spot transaction to postpone the spot transaction until the date of term value that it actually needs.
Acceptance of this swap transaction will move the value date of the Company’s hedge from the spot value to a value date three months later. This will also change the exchange rate on the transaction from +0.0001 or from 1.0200 to 1.0201.
Understand the reasons for currency swaps
Currency swaps are used for several reasons. The reason will usually depend on whether the user is a hedger or a trader.
Changing value dates
Many forex market participants need to change the value date of their forex positions. This need ranges from traders who manage day-to-day positions to companies that need to hedge their future exchange rate exposures.
Reducing the exchange rate risk of a futures contract
Foreign exchange swaps allow those wishing to execute a direct forward transaction for a future delivery date to virtually eliminate their exchange rate risk by first quickly entering into a spot transaction and then exchanging that position on the date desired term value.
Advantages of entering into a currency swap
The general advantage of entering into a currency swap is that it allows a trader or hedger to change the value date of their position in a particular currency pair. A currency swap can almost eliminate their currency risk that would otherwise be involved by first closing a position for one value date and then opening a position for another value date for the same amount but in the opposite direction.
Another benefit of using FX swaps applies specifically to those who are engaged in forex trading if they are managing overnight positions, as they can avoid the hassle of the currency delivery process and can also keep their easily tradable forex positions in the spot market.
These traders typically maintain the value of their trading position by using daily tom-next swaps, also often called rollovers, which are typically performed just after the New York close at 5:00 PM EST or early the next morning.
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