This forex course basics section covers the nature of forward foreign exchange transactions and the forward market.
The term “Foreign Exchange Swap” refers in the forex market to a “two-legged” or two part currency exchange transaction. Swap trades are typically used by forex traders to “swap” or shift a foreign exchange position’s value date to another date that is usually further out in time. This would commonly be referred to as “swapping out” or “rolling out” the position among professional forex traders.
In addition, the forex market term “forex swap” often refers to the number of “swap points” or pips that traders will need to increase or reduce the near date exchange rate by to get the desired forward rate.
Why Forex Swaps are Used
Forex swaps are often used to roll out positions held for value spot or tom (tomorrow) to longer value dates. They are especially popular among corporations using forwards to hedge their significant currency exposures or cash flows.
They are also used by traders who need to roll spot positions that were held overnight from value tom to value spot. These are usually called “tom/next swaps” or “rollovers”, and many brokers automatically perform them for their clients if a trading position is held over 5pm EST.
Forex Swaps in Practice
The initial part of a forex swap deal involves a specified currency and amount being bought or sold against the second currency at a certain rate and date. If this date is the first to arrive, then it would be called the near date of the swap.
The second part of the swap usually involves the same amount of currency then being sold or bought versus the second currency with an agreed exchange rate and value date. If this date is further out than that in the first part or leg of the swap, then it is known as the far date of the swap.
Since they either involve buying and selling or selling and buying equal amounts of one currency, forex swaps generally result in very little overall spot rate exposure and so they present a lower trading risk than a spot position.
Swap Points and Carry Costs
Forex swap points can be mathematically derived by computing the interest that might accrue to the base currency’s holder versus the interest that might accrue to the counter currency’s holder during the forward contract’s duration.
The difference between these accrued interest amounts is commonly referred to as the cost of carry or as simply “the carry”, which can be positive or negative depending on the particular currency pair involved.
Furthermore, the swap points are valued according to the number of days between the spot value date and the value date of the forward contract; in addition to the prevailing Interbank deposit rates relating to the two currencies involved in the transaction.
Typically, the carry on a forex forward transaction is positive when the currency with the higher rate of interest is sold forward since the trader gets the benefit of holding that currency during the time before delivery.
Conversely, the cost of carry is generally negative when buying the currency with the higher rate of interest forward. The cost of carry will be negligible and the swap will approach zero if the interest rates of both currencies are roughly equal.