What is an FX Swap?

This article will focus on the type of swap forex traders typically use, so read on to find out more about how FX swaps work and additional useful information about them that those already engaged in forex trading or learning how to trade forex might need to know. 

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How Does an FX Swap Work?

An FX Swap is a financial transaction in which two parties exchange currencies at one point in time and agree to reverse the exchange at a later date. Essentially, it combines two separate transactions:

1. Spot Transaction: An immediate exchange of one currency for another at the current market rate (spot rate).
2. Forward Contract: An agreement to reverse the exchange at a future date, using a pre-agreed rate (forward rate).

Purpose of FX Swaps:

• Hedging: Companies or investors use FX swaps to hedge against exchange rate risk when they have international exposures.
• Liquidity Management: Financial institutions use FX swaps to access foreign currencies for short-term liquidity needs.

For example, if a U.S. company needs euros today but will have euros in the future, it can enter into an FX swap to obtain euros now and repay them later, mitigating the risk of exchange rate fluctuations.

What is the Process of an FX Currency Swap?

An FX swap is generally done between two counterparties that own or can deliver different currencies. For example, the two legs of a possible swap transaction might be:

Leg 1 takes place at the initial date of the currency swap transaction, typically at the prevailing spot rate. The parties will exchange or swap their respective currencies in equivalent amounts given that particular spot rate.

Leg 2 takes place at the maturity date of the swap at the forward exchange rate. This process involves a second swap of the agreed-upon currency amounts taking into account any forward swap points that depend on the interest rate differential between the two currencies. The direction of this swap of currencies is the reverse of the initial swap done in Leg 1. 

What are the Types of Swaps?

While all currency swaps involve swapping one value date for another for a position in a currency pair, certain commonly performed forex swaps have special names. A list of common short-dated FX swaps include:

• Overnight swap: A swap from today’s date against tomorrow’s value date.
• Tom-next (T/N) swap: A swap from tomorrow’s value date against the next business day.
• Spot-next (S/N) swap: A swap starting at the spot value date against the following business day.
• Spot-week (S/W) swap: A swap starting at the spot value date against a week later.
  

The tom-next foreign exchange swap is perhaps the most well known of these specially-named swap transactions since forex traders who hold positions overnight generally perform that swap when doing their rollovers after 5 p.m. New York time. Most online forex brokers automatically perform that swap for their clients to keep their trading position’s value spot.

What is the Difference Between an FX Forward and an FX Swap?

An FX forward, also sometimes called a forex forward outright transaction, is a one-legged transaction executed for a forward value date that differs from the current spot value date. In contrast, an FX swap is a two-legged transaction that swaps a forex position from one value date to another that is usually further out in the future.

It is a common practice among forex market participants to execute forward outrights by first doing a spot transaction and then performing an FX swap to swap the spot position out to the desired value date. This process lets a trader quickly cover their more volatile spot market risk and then roll the position out to a future value date at a more leisurely pace using the far more stable swap points quoted by forex forward traders. 

Example of an FX Currency Swap

Consider an example where a U.S. corporation needs 10 million euros to pay for a contractual purchase that will be consummated three months in the future. To quickly protect its forex risk from anticipated market volatility, it has already purchased the required euros with U.S. dollars at a spot EUR/USD exchange rate of 1.0200. 

That transaction will deliver in two business days instead of in three months’ time when the euros are actually needed. The corporation thus obtains a quotation for a EUR/USD FX swap of +1 pip or +0.0001 from the same financial institution it did the initial spot transaction with to roll the spot transaction out to the forward value date it actually needs. 

Agreeing to that foreign exchange swap transaction will move the value date of the corporation’s hedge forward from value spot to a value date three months in the future. It will also change the exchange rate on the transaction by+0.0001 or from 1.0200 to 1.0201.

Understanding the Reasons for FX Swaps

FX swaps are used for several reasons. The reason will typically depend on whether the user is a hedger or a trader.

Changing Value Dates

Many forex market participants need to change the value date on their forex positions. This need ranges from traders who run overnight positions to corporations that need to hedge future exchange rate exposures. 

Reducing the Exchange Rate Risk of a Forward Outright

FX swaps allow those who wish to execute a forward outright transaction for a future delivery date to virtually eliminate their forward rate risk by quickly doing a spot transaction first and then swapping that position out to their desired forward value date.

Benefits of Entering into an FX Swap

The general benefit of entering into an FX swap is that it lets a trader or hedger change the value date of their position in a particular currency pair. An FX swap can almost eliminate their exchange rate risk that would otherwise be involved in first closing out a position for one value date and then opening up a position for another value date in the same amount but the opposite direction.

Another benefit of using FX swaps applies specifically to those engaged in trading forex if they run overnight positions since they can avoid going through the hassle of the currency delivery process and can also keep their forex positions readily tradable in the spot market. 

Such traders generally keep their trading position’s value spot using daily tom-next swaps, also often known as rollovers, that are generally performed just after the New York close at 5 p.m. EST or early the following morning. 

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