FX Swap

 

Summary:

• An FX swap is a financial agreement where two parties simultaneously exchange amounts in one currency for an equivalent amount in another currency, with two different settlement dates.
• FX swaps are risk management tools that enable businesses to secure more favourable interest rates than those offered by local institutions, while maintaining their preferred currency for interest payments.

 

FX Swaps explained:

• What is an FX Swap?
• What are FX swaps used for?
• How does an FX swap work
• Advantages of FX swaps
• Risks of FX swaps
• FX swap example
• Cross currency swap vs FX swap
• FX swap vs FX forward

 

What is an FX Swap?

A foreign exchange swap (FX swap) is an over-the-counter (OTC) derivative where two parties agree to exchange a notional amount in different currencies at the spot rate, with a commitment to reverse the exchange at a predetermined forward rate on a specified future date.

FX swaps are used to manage currency risk or gain foreign currency liquidity by leveraging the difference between the spot and forward rates.

 

What Are FX Swaps Used For?

FX swaps are commonly used by businesses and investors with exposure to multiple currencies who wish to manage foreign exchange (FX) risk.

FX swaps can:

• Help businesses secure more favourable interest rates than those offered by local institutions, while maintaining their preferred currency for interest payments.
• Provide a hedge against adverse FX movements in foreign investments and the associated interest income
• Enable businesses to swap between floating and fixed interest rates simultaneously, offering greater flexibility in managing interest rate exposure.
• Serve as an effective tool in FX risk management, allowing companies to manage currency exposure while meeting financial goals.

 

How does an FX Swap work?

An FX Swap is a financial instrument used to manage currency risk or obtain FX liquidity. It involves two transactions, typically swapping notional principals between currencies:

Leg one – Spot exchange: The two parties exchange a specified notional amount in one currency for an equivalent amount in another currency at the current spot rate.

Leg two – Forward exchange: At a predetermined future date, the two parties reverse the transaction at a pre-agreed forward rate, which usually differs from the spot rate and accounts for expected changes in the exchange rate over time. The notional amounts are swapped back to their original currencies.

The notional amount determines the interest payments exchanged, but no actual principal is exchanged—only the interest on the notional amounts.

 

Advantages of FX swaps

Protection against market volatility

Engaging in swaps provides a safeguard against negative currency movements, ensuring that the exchange rate is fixed for a predetermined future date. This means that businesses can protect themselves from unexpected financial losses due to sudden changes in currency values, allowing for more predictable financial planning and stability.

Potential to reduce costs

By using FX swaps, funds and corporates can eliminate the necessity for numerous individual FX spot contracts, each of which may incur various associated costs such as FX transaction fees and administrative expenses. This consolidation of contracts into a single swap agreement can lead to reduced FX costs, enhancing overall financial efficiency.

Flexibility

The terms of a swap agreement can be customised to suit the specific needs and objectives of both parties involved. This flexibility allows each party to tailor the agreement to address their unique financial goals, risk tolerance, and market position, making swaps a versatile tool in managing financial risk and optimising financial strategies.

 

Risks of FX swaps:

Exchange rate fluctuations

The rate at which the initial currency is swapped back at maturity is predetermined, but any adverse movements in the market exchange rates during the FX swap period can lead to potential losses or diminished returns for the parties involved.

Counterparty credit risk

If one of the parties involved defaults, this can result in major losses and affect the overall businesses performance.

Liquidity risk

This typically occurs when market liquidity is too low making it difficult to enter or exit positions without significantly impacting the exchange rate or incurring high transaction costs. It is particularly problematic in volatile currency markets, where finding counterparties to execute Swaps or adjust existing positions can be challenging and expensive.

 

FX swap example

Below is an example of how an FX swap can be used for currency exchange management:

Swap requirement

Company A: Requires to access euros (EUR) for operations or investments in the Eurozone.

Company B: Requires British pounds (GBP) for activities or investments in the UK.

 

Step 1 - Initial exchange of principal (spot transaction)

At the start of the FX swap, the counterparties exchange the principal amounts at the current spot rate.

Assume the spot rate is 1 GBP = 1.20 EUR.

• Company A (GBP side): Pays £10 million to Company B.
• Company B (EUR side): Pays €12 million to Company A (10 million GBP * 1.20 EUR/GBP)

 

Step 2 - Final exchange of principal (FX forward transaction)

At the end of the swap, the counterparties reverse the initial principal exchange at an agreed forward rate.

Assume the forward rate is 1 GBP = 1.25 EUR.

• Company A (GBP side): Pays €12 million to Company B
• Company B (EUR side): Pays £9.6 million to Company A (12 million EUR / 1.25 EUR/GBP = £9.6 million)

 

Cross currency swap vs FX swap 

A cross-currency swap and an FX swap are both tools for managing FX risk, but they differ in key ways. The table below highlights the main distinction:

		Cross currency swap		FX swap
Purpose		A medium to long-term transaction, typically used for liquidity management, FX risk and interest rate risk management.		A short-term transaction, typically used for liquidity management and FX risk management.
Exchange of notional principles		Yes, the principal amounts in different currencies are exchanged at the start and reversed at the end of the transaction.		Yes, the principal amounts in different currencies are exchanged at the start and reversed at the end of the transaction.
Interest Payment Exchange		Yes, interest payments based on the notional principal are exchanged periodically.		No, the interest differential is incorporated into the forward rate.
Maturity		Long-term contracts, often spanning several years.		Short-term contracts, usually ranging from a few days to up to one year.
Interest Rate Types		Can involve both fixed and floating interest rates, depending on the terms of the agreement.		Typically involves floating interest rates based on prevailing market rates.

 

FX swap vs FX forward

FX forwards and FX swaps are both over-the-counter (OTC) derivatives. Both involve foreign exchange transactions set for future dates and are used to hedge against currency risk or to speculate on future exchange rate movements.

The key difference is that an FX forward involves a single exchange of currencies at a future date, while an FX swap includes both an initial exchange and a future reversal of currencies.

The table below outlines additional differences between FX swaps and FX forward contracts:

		FX Swap		FX Forward
Definition		An agreement to exchange two currencies or financial instruments over a set period, with the reverse exchange at a future date.		An agreement to buy or sell an asset at a predetermined future date and price, typically for a single exchange.
Transaction Type		Two transactions: Initial exchange at the spot rate and reverse exchange at a predetermined forward rate.		One transaction: Exchange of currencies at a predetermined future date, using an agreed exchange rate.
Interest Rate Exchange		Interest rate exchanges may occur as part of the agreement, depending on the terms.		Interest rate exchanges are not typically involved in FX forwards.
Flexibility		Moderate flexibility in adjusting terms (currency pair, interest rates).		Less flexibility, as it is usually a straightforward contract with fixed terms.
Risk Management		Helps hedge FX risk and interest rate risk over the term of the swap.		Primarily used for hedging against currency risk without interest rate considerations.

​