Basically, Forex swap refers to the act of changing or “swapping” the value date of a particular currency pair to a later time.
Forex swaps are usually very important, especially for financial institutions, speculators, or even banking institutions.
They are mainly used for the purpose of changing the dates on liabilities involving foreign currencies. For speculators, such as Forex brokers, they will be used mainly for accounting purposes, where a broker can opt to convert their client’s balances into home currencies and later reconvert them.
Forex swaps are basically very important for financial institutions, where they can be used to create derivatives. They mainly occur outside of a market and therefore do not really affect the market price.
Types of Forex swaps
Forex Swap with an exchange of cash flows
This refers to a type of swap where the exchange of cash flows will be denominated in foreign currencies, which also includes the exchange on principals.
Credit Default Swap (CDS)
This is a type of swap that is usually relevant to currency traders, and it functions as an insurance protection against the possibility of a bond default. A Credit Default Swap (CDS) buyer will need to pay an upfront premium as well as an annual premium to a writer, who will contractually be obligated to pay compensation in the event of a default or even underlying credit instrument.
This type needs to be converted into a currency to either be added or subtracted from the spot rate. It is mainly calculated from the number of days from a spot to a forward date, together with a prevailing inter-bank deposit rate for both currencies to a forward date.
How it Works
In swapping, one type of currency will be bought or sold against another currency at an agreed rate and on an initial date, which can also be called a near date, as it is almost relative to the date currently being used.
In the second part of the transaction, a similar quantity will either be sold or bought simultaneously against another currency at another agreed rate on another value date, also known as a ‘far date’.
The transaction will then deal effectively with no net exposure to a current spot rate, as the first transaction will open up to a market risk. The second part of the transaction will then close it down.
Different types of usage
Forex swaps are very effective in currency trading, especially when a trader wants to move forward an open Forex position to a future date, and avoid any kinds of delay with the particular agreement made. It can also be used to make the agreement date of delivery closer.
For instance, if a corporation or organization finds out that a particular contract or agreement is going to be delayed for a month or so, they will use Forex swap to move it to an earlier date.
Using a Forex swap, organizations are able to avoid lowering interest rates or even acquiring lower interest rates that they would have otherwise obtained.
Companies are mainly able to avoid fluctuations and easily take advantage of the future rates.
The exchange rates are usually volatile. Therefore, swaps give protection from certain events or unfavorable movements and ensure cash flow certainty.
There is a possibility of being able to take advantage of the current markets while using a Forex swap.
Despite the high risks that they have, financial institutions, central banks or even brokers prefer using Forex swaps as they have been known to increase interest rates and also make profits easier by avoiding future uncertainties.
It is also easy to get currencies of other denominations based on agreed rates and dates, where they can be reconverted later at agreed dates and rates.
However, there are also drawbacks where one cannot be able to take advantage of exchange rates for a particular transaction at a specific time.