A foreign exchange swap is a two part currency transaction used to swap the value date for FX position of a particular currency pair to a later time. Foreign exchange swaps are important, especially for the entrepreneur, financial institutions, or even banking institutions.
Why FX Swaps Are Used?
It is often used when a trader needs to roll an existing open forex position forward to a further date to avoid the delivery required on the contract. It is also often swapped to bring the delivery date closer. For example, forex brokers will use it mainly for accounting purposes; the clients balance is converted into home currency and then later reconverted. A corporate uses forex swap for hedging purposes if already protected currency cash flow with forward outright contract, was actually going to be delayed for an additional month. Forex swaps are very important for financial institutions.
Types Of FX Swaps
1. Interest Rate
It is an agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of series of cash flows. A fixed rate – here the payer makes a series of fixed payments and at the beginning of the swap these cash flows are known. At floating rate the payer makes a series of payments that depends on the future level of interest rates and at the beginning of the swap most of the cash flow is not known. An interest swap rate is priced by the first present valuing each series of swap and then combines the two results.
2. Credit Default Swap
This type is most relevant to currency traders as it functions as insurance protection against the possibility of bond default. The buyer will need to pay an upfront premium as well as an annual premium to the writer, who under the contract will be forced to pay compensation in the event of default.
This type is converted into a currency to be added or subtracted from the spot rate. It is mainly calculated from a spot rate to a forward date, together with existing inter -bank deposit rate for both currencies to a forward date.
How An FX Swap Works
In the first phase, a particular quantity of currency is bought or sold versus another currency at an agreed rate on an initial date. It is often called near date since it usually the first date to arrive relative to the current date. In the second phase, the same quantity of currency is then sold or bought simultaneously versus the other currency at a second agreed upon rate on another value date, often called the far date.
The swap deal successfully results in no net exposure to the existing spot rate, since the first phase opens up spot market risk and the second phase immediately closes it down.
Despite the high risks, financial institutions, central banks, and entrepreneur prefer using FX swap as it increases interest rates and also makes profits easier avoiding future qualms. It is also easy to get currencies of other denominations based on agreed dates and rates.