In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).[1] see Foreign exchange derivative.

Structure

A foreign exchange swap consists of two legs:

• a spot foreign exchange transaction, and
• a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other.

It is also common to trade forward-forward, where both transactions are for (different) forward dates.

Uses

The most common use of foreign exchange swaps is for institutions to fund their foreign exchange balances.

Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency, and a negative (or short) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back settling the day after.

The interest collected or paid every night is referred to as the cost of carry. As currency traders know roughly how much holding a currency position will make or cost on a daily basis, specific trades are put on based on this; these are referred to as carry trades.

Pricing

The relationship between spot and forward is known as the interest rate parity, which states that

$F = S \left( \frac{1+r_d T}{1+r_f T}\right) ,$

where

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

$F - S = S \left( \frac{1+r_d T}{1+r_f T} -1 \right) = \frac{S (r_d - r_f) T}{1+r_f T} \approx S \left( r_d - r_f \right) T ,$

if $r_f T$ is small. Thus, the value of the swap points is roughly proportional to the interest rate differential.

Related instruments

A foreign exchange swap should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.