What is Forex Currency Swap?
Forex currency swap helps reduce foreign borrowing costs and mitigate exchange rate risks. It provides borrowers with a higher opportunity to profit from the foreign exchange market. In our article, we will discuss the forex currency swap in depth.
What is a currency swap?
A foreign exchange swap is a legal agreement between two parties (a borrower and a lender) in which the borrower agrees to simultaneously borrow (purchase) a particular currency for another currency, and the lender agrees to lend (sell) this currency for the former currency. The agreement matures at a later date but pre-decided exchange rate. At maturity, the amount difference between the two currencies is exchanged. For example, let's assume you decide to trade USD/EUR and swap USD (purchase currency) for EUR (selling currency) at the exchange rate of 1.5. This means to buy 1.5 USD, you will have to sell 1 EUR. You decide to enter a USD/EUR currency swap agreement at the exchange rate of 1.3 at a later date. The later date is exactly one trading week after the agreement is made. As the maturity date arises, the exchange rate has decreased to 1.1. This means that now, to buy 1.3 USD, you need to sell 1 EUR in contrast with the previous exchange rate of 1.5, where you could get 1.5 USD for 1 EUR. Hence, EUR has become more expensive. However, since you already have a currency swap agreement at the exchange rate of 1.3, you will get 1.3 USD by selling 1 EUR, which is higher than the prevailing exchange rate of 1.2. This saves you the risk that comes with the bearish trend. Assuming the currency swap process is applied to the real world, a European company wishes to borrow $100 million from a US company and lends 50 million euros in return; the exchange rate between USD/EUR is 2 at the time of agreement. They decide to end the contract six months after the beginning date at the exchange rate of 2 itself. Let us assume that the exchange rate increases to 3 at the time of maturity, which means that if the European company did not enter into a contract with the US company, they would have to return $150 to receive 50 million euros. However, since the contract is valid, the European company will only have to return as much as they borrowed to get back their 50 million euros.
Stages in a currency swap
There are three stages in a forex currency swap –
1. Spot the forex market
The first stage is to spot a foreign exchange market and the currency pair that the borrower wants to swap. The currencies to be swapped are mentioned in the swap agreement.
2. Exchange interest payments
In this stage, the forex contracts are forwarded as per the pre-decided date of maturity. When the contract is fixed at a pre-decided exchange rate to be exchanged at a pre-decided time, the spot rate is considered at the beginning of the swap’s life cycle.
3. Principle exchanged at maturity
The last stage is where the principal amounts of the buying and selling currencies are exchanged. If the buying currency appreciates in value, the borrower faces some loss, and if the selling currency appreciates in value, the borrower makes a gain due to the currency swap process. The principal amounts can be exchanged in three ways:
- At the beginning of the contract
- At a combination time period of the start and end
- At the end of the contract
Types of currency swaps
Fixed for Fixed
The fixed for fixed swap is a type of forex currency swap in which there are two parties exchanging currencies with each other. Both parties pay a fixed interest rate to one mother on the principal amount. This helps them mitigate interest rate risks and benefits borrowers in countries where interest rates are cheaper.
Fixed for Floating
The fixed for floating swap is a type of forex currency swap in which there is an agreement between two parties wherein one party agrees to swap an interest of a country’s currency following a fixed rate with that of a country’s currency floating a floating rate. The principal is not exchanged, and only the difference between the two interests is. It benefits borrowers if the floating rate interest is lower than the fixed rate interest.
Floating for Floating
The floating for floating swap, also called basis swap, is a type of forex currency swap in which there is an agreement between two parties to exchange interest payment and principal of one country’s currency with a floating rate with that of another country’s currency with a floating rate as well. In this agreement, interest rates are exchanged at fixed and regular intervals.
Return-based swap is a type of forex currency swap in which there is an agreement between two parties, wherein one party agrees to make a payment based on a pre-decided rate (fixed or variable), whereas the other one makes the payment based on the currency’s returns.
Forex currency swap timeframes
Short-term timeframe currency pair swaps last anywhere between one day to one week. It helps borrowers profit from short-term volatility and quick price fluctuations. Here is what the short-term timeframe swaps are called:
- Overnight swap: This sap is agreed on today against the currency pair value tomorrow.
- Tom-Next swap: This swap is agreed for tomorrow against the next day.
- Spot-Next swap: This type of swap is behind in the spot market T+2 days later against the day after it.
- Spot-Week swap: This type of swap starts in the spot market against the currency pair value a week later.
Medium-term timeframe currency pair swaps last anywhere between a few months to a year. It helps borrowers profit from the spread-out currency pair price fluctuations and benefits from bigger economic events. In this timeframe, borrowers can exchange a currency pair with another at a pre-decided date after a month, 4 months, 6 months, 10 months, or one year minus one trading day.
The long-term timeframe currency pair swap lasts anywhere between 1 year to 10 years. It is the longest timeframe and allows borrowers to benefit from major price movements and extremely big and significant economic events. If you enter into such an agreement, both parties exchange the amount after a year, 2 years, 3 years, 4 years, 5 years, and so on.
How do forex currency swaps work
Currency swaps are tied to the London Interbank Offered Rate, also termed LIBOR, which is the average interest rate followed by international banks to borrow from one another. It is used as an international benchmark. In a forex currency swap, both parties agree to pay interest on the other party’s loaned-out principal amount according to the currency pair’s exchange rate as long as the agreement lasts. As soon as the maturity date arises, if the entire principal amount has been exchanged, the amount is exchanged for one last time on the spot or agreed rate.
Benefits of forex currency swaps
Reduces exchange rate risk
Forex currency swaps reduce exchange rate and price fluctuation risks as the agreement fixes an exchange rate at which the currencies are swapped. This is useful for borrowers trading currencies in the international market as the international market is dynamic and affected by several financial and economic events. It helps investors to open opposite and simultaneous positions in different currency pairs to protect themselves against any significant exchange rate risks. Opening multiple opposite swaps together ensures that if one swap bears a loss, the opposite swap is able to offset it.
Gain from trade
The gain from trade is a type of benefit which exists in most currency swaps. This refers to a situation in which the borrower is able to borrow a currency at a lower rate when compared with the present or future foreign rate. The profit is the difference between the agreed rate and the existing rate.
Foreign currency exposure is eliminated with domestic currency
When you borrow the domestic currency and exchange it for a foreign currency at the spot rate, you can receive foreign currency cash flow and benefit from the same. When the spot rate fluctuates favourable, the borrower pays less than originally borrowed and reaps profits. This increases international cash flow for the borrower.
Assists speculators profit
Speculators are the forex borrowers who accept market risk to make a profit by predicting or speculating on the market movement. They place orders based on their understanding of how the prices are going to fluctuate and generally buy low and sell high. Currency swaps benefit speculators as it allows them to enter into an agreement based on their own speculation. Thereafter, any favourable change in the interest rate helps them earn a profit.
Currency switch based on future expectation
With a currency swap, you can switch from one currency to another based on predicting the future performance of the currencies. If you feel that the currency that you have purchased is going to witness a downtrend and the currency against is going to rise, you can enter a currency swap agreement wherein you sell the existing currency that you have to buy more of the other one with a positive future outlook. This way, you can protect yourself against future price momentum.
Undo bad currency decisions
If you entered into a contract where you purchased a currency that has not done well in the market, you could undo this decision through a currency swap. You can exchange this currency for a better currency that has been performing well in the market. Restructuring the currency base in your portfolio increases the probability of forex profits.
Since there is extreme liquidity in the currency swap market, you do not have to worry about the supply or demand of the currency pairs failing. The more the supply/demand of the currencies in the market, the higher the success rate of your currency swap order completion.
Reduces interest rate risk
Interest rate risk refers to an increase or decrease in the interest rate in countries, which may negatively affect the country’s currency in the forex market. Such a change in interest rate is triggered by economic or financial events, including recessionary or inflationary pressures. You can reduce the interest rate risk associated with the currencies you are trading by entering into a currency swap agreement. Since this agreement fixes the exchange rate at a pre-decided maturity period, any fluctuation in the interest rates does not hamper the currency’s price in the forex market. So, even if the currency pair you are holding depreciates in value at the maturity period, you will still receive the value that was agreed upon at the time of the agreement.
What is a currency swap agreement
A currency swap agreement is a legal document in which a borrower and a lender agree to exchange two different currencies at a fixed or floating rate with a pre-decided maturity date of the agreement. At maturity, the amount borrowed is returned. This helps in matching the currency’s future and spot rates over a specific period of time and avoiding price fluctuation risks. The loan principal is included in the agreement, and both parties agree to swap the principal amounts in their respective currencies. Since the amount to be returned is fixed, any future change in the value of the two currency pairs makes no difference for the borrowers and lowers borrowing costs as well.
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