In financial terms a forex swap or even FX swap as you might have often hear the term being abbreviated is a spontaneous purchase and sale of the exact same amount of one currency for another with 2 different value dates. The actual practice of forex swap consists of 2 main legs which include a spot foreign exchange transaction and a forward foreign exchange transaction; the process is commonly known to be adopted by forex institutions to swap their very own balances.
In simple terms once the exchange transaction has found a position to settle, the holder finds himself holding a positive currency position in regards to one currency and a negative position in regards to the second on which the financial institution will reinstitute the following day after it has closed any foreign balances in order to collect or pay overnight interest due. The interest due is known as the cost of carry which experienced currency traders are aware of in rough balances therefore making the cost or the profit of their trades a somehow predictable practice.
A currency swap is a forex agreement in which two parties or two traders exchange aspects of a loan in once currency for equivalents aspects of an equal loan in a foreign currency, currency swaps are based on the foreign exchange derivative and are clearly motivated by comparative advantage; the basis on which a currency swap is distinguished is the central bank liquidity swap. Currency swaps are very much related factors to interest rate swaps with the only difference that they can invlove the exchange of the principal where in interest rate swaps they cannot.
Currency swaps can commonly exchange loans in three instances with the first and most common being the case when the principal exchanges only with the counterparty at a rate agreed now but executed in a time forward in time. These kind of agreements are often very much equivalent to forward contracts or futures but are notably an expensive process as the process of finding a counterparty is in most cases accomplished with the intervention of a third party.
The second most common currency swap is when combining the exchange of a loan principal with an interest rate swap where cash flows which occur from interest are not netted before they are paid to the counterparty as they are not denominated in a different currency.
In this case realistically each party borrows on somebody else’s behalf the type of swap is often abbreviated as a back to back loan. The last but also popular type of currency swap is swapping interest payment cash flows with loans of the same size and term; as this particular practice still falls in the category of currency swaps the exchanged cash flows are again in different denominations and therefore again are not netted.
A common example is the exchange of a fixed rate US dollar payment which has occurred from interest for a floating rate in Euro; the particular type of swap is commonly known as a cross currency swap.
Currency swaps go back to the 1970’s when they were used to circumvent forex controls in the UK; back in time British companies were obliged to pay a premium in order to borrow in USD which was the reason companies engaged in back to back loan agreements with US companies that wanted to borrow £ Sterling.
The introduction of cross currency swaps were introduces in 1981 by the World Bank in order to obtain Swiss Francs and German Marks by exchanging cash flows with IBM; the agreement back then had been introduced by the Salomon Brothers with a brokerage role under a notional amount of $210 million and a term exceeding a ten year period. The most recent example of a currency swap can be traced in 2008 by the US Federal Reserve which during the introduction of the financial crisis in order to establish a central bank liquidity swap.
The process was adopted by exchanging domestic currency at the current market exchange rate with an agreement to reverse the currency swap at a predefined future date. The ultimate goal is for the US to provide liquidity in USD in overseas markets in order to prevent stagnation.