1. What is a Forex Swap Transaction and How Does It Work?
A foreign exchange swap is a two-part or “two-legged” currency transaction in the forex market that is used to transfer or “swap” the value date for a foreign exchange position to a later date. When pricing a foreign exchange swap transaction, the phrase “forex swap” may also refer to the number of pips or “swap points” that traders add or remove from the starting value date’s exchange rate, frequently the spot rate, to achieve the forward exchange rate.
The first leg of a forex swap transaction involves buying or selling a certain amount of one currency against another at an agreed-upon rate on an initial date. This is sometimes referred to as the close date since it is generally the first date to come in relation to the present date.
The same amount of currency is then concurrently sold or bought vs the other currency at a second agreed upon rate on another value date, frequently referred to as the distant date, in the second leg.
Because the first leg of the swap opens up spot market risk, the second leg of the swap instantly closes it down, this forex swap arrangement essentially results in no (or very little) net exposure to the prevailing spot rate.
2. The Cost of Carrying and Forex Swap Points
The whole cost of lending one currency and borrowing another throughout the time period ranging from the spot date to the value date will be calculated mathematically to determine the forex swap points to a certain value date.
This is frequently referred to as the “cost of carry” or simply the “carry,” and it is translated into currency pips before being added or removed from the spot rate. The carry may be calculated by adding the number of days from the spot date to the forward date, as well as the current interbank deposit rates for the two currencies to the forward value date.
In general, the carry for the party selling the higher interest rate currency forward will be positive, whereas the carry for the party buying the higher interest rate currency forward would be negative.
3. Why is Forex Swaps Used?
When a trader or hedger has to roll an open forex position forward to a future date in order to prevent or postpone contract fulfillment, a foreign currency swap is frequently employed. A FX exchange, on the other hand, can be used to push the delivery date closer.
For example, FX traders may frequently use “rollovers,” also known as tom/next swaps, to extend the value date of a previously placed spot position to the current spot value date. On positions open after 5 p.m. EST, some retail forex brokers would even do these rollovers automatically for their clients.
As a result, they may just roll out their current forward outright contract hedge one month in this event. They would do this by agreeing to a currency swap in which they would close out the present near-term contract and create a new one for a month later.