A foreign exchange Swap is a product that is used by traders who want to exchange two currencies on one day and to swap or re-exchange the same currencies at a later day.
A foreign exchange swap is an agreement between complimentary parties who agree to exchange one currency for another.
The exchange takes place at predetermined times and does not incur foreign exchange risk.
The exchange agreement of the two currencies include:
- A fixed Term and
- A Pre-Agreed Swap Rate
An FX Swap is a synchronized sale and purchase transaction that has two payment dates, the start date, and the end date.
The Start Date refers to the day when the currency or currencies are first exchanged for another at an agreed exchange/swap rate. While the End Date refers to the day, the currencies are exchanged back at the agreed swap/exchange rate.
Normally, the exchange or swap rate for each of the transactions is usually different, and experts refer to the difference as swap points.
Apart from being set by the market, the swap points usually reflect the current interest rates of the different parties involved during the period of the foreign exchange swap.
By either adding or subtracting from the spot rate, the swap points can either represent a discount or a premium to a trader.
Purpose of Foreign Exchange Currency Swaps
Procuring loans in foreign currency at conducive interest rates in comparison to borrowing directly in a foreign market is supposedly the main reason for engaging in a currency swap.
The World Bank first introduced foreign exchange currency swaps in 1981 in an endeavour to get Swiss francs and German marks.
Foreign currency swaps are commonly done on loans that have maturities of up to 10 years. Foreign currency swaps should not be mistaken with interest rate swaps as the later also involve principle exchange rates.
In a foreign currency swap, respective parties continuously pay the interest rates on the swapped currency amounts throughout the loan.
Once the swap is over, the pre-agreed amounts are exchanges again at a pre-agreed rate, avoiding transaction risks and spot rates.
Main Types of Foreign Currency Swaps
At present, the fixed-for-fixed and fixed-for-floating foreign currency swaps are the main types of currency swaps in the market.
The fixed-for-fixed currency swap involves parties paying each other a fixed interest rate on the pre-agreed amount.
The fixed-for-fixed swap can be utilized to take advantage of conditions where interest rates of one country are cheaper than the other.
In the fixed-for-floating swap, one party swaps the interest cash flows with the floating rate loans that are held by the other party.
Benefits of a Foreign Currency Swap
A foreign currency swap allows traders to exchange one currency for another one on an agreed date and an agreed exchange rate, re-exchanging the currencies on a later date and at an agreed exchange rate.
As we all know by now, exchange rates are highly volatile. One of the benefits of using a foreign currency swap includes client protection in case of unfavourable price movements occurs in exchanges.
Foreign currency swaps also avail greater cash flows to the parties involved.
Disadvantages of Foreign Currency Swaps
One of the main disadvantages of a foreign exchange swap is probably the inability to take advantage of any favourable price movements in exchange rates once in a foreign exchange swap.
The end dates of the swaps cannot be extended. In an event, the foreign currency swaps are no longer needed; parties cannot cancel the agreement. The swap agreement must be settled and fulfilled.
Risks of a Foreign Currency Swap
As it is well known, foreign currency markets are highly volatile. It is almost impossible to predict how exchange rates are going to move to lead to currency risk.
Adverse changes in the exchange rates after the swap can lead parties to incur losses that are so severe that the swap acts against the parties.