What is "FX Swap"?

FX Swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (typically spot to forward). The two parties agree on currency exchange on one day and simultaneously agree to reverse that deal on a date in the future. That is, the two parties have the right to use the exchanged currency at a specific time.

Understanding Foreign Currency Swaps

The purpose of engaging in a currency swap is usually to procure loans in foreign currency at more favorable interest rates than if borrowing directly in a foreign market. The World Bank first introduced currency swaps in 1981 to obtain German marks and Swiss francs. This type of swap can be done on loans with maturities for as long as ten years. Currency swaps differ from interest rate swaps in that they also involve principal exchanges.

In a currency swap, each party continues to pay interest on the swapped principal amounts throughout the length of the loan. When the trade is over, principal payments are exchanged once more at a pre-agreed rate (which would avoid transaction risk) or the spot rate.

There are two main types of currency swaps. The fixed-for-fixed currency swap involves exchanging fixed interest payments in one currency for fixed interest payments in another. In the fixed-for-floating swap, fixed interest payments in one currency are exchanged for floating interest payments in another. In the latter type of swap, the principal amount of the underlying loan is not exchanged.

The basic mechanics of FX swaps and cross-currency basis swaps

An FX swap agreement is a contract in which one party borrows one currency and simultaneously lends another to the second party. Each party uses the repayment obligation to its counterparty as collateral, and the repayment amount is fixed at the FX forward rate as of the contract's start. Thus, FX swaps can be viewed as FX risk-free collateralized borrowing/lending. The chart below illustrates the fund flows involved in a euro/US dollar swap as an example. At the contract's start, A borrows X·S USD from and lends X EUR to B, where S is the FX spot rate. When the contract expires, A returns X·F USD to B, and B returns X EUR to A, where F is the FX forward rate as of the start.

FX swaps have been employed to raise foreign currencies, both for financial institutions and their customers, including exporters and importers, as well as institutional investors who wish to hedge their positions. They are also frequently used for speculative trading, typically by combining two offsetting classes with different original maturities. FX swaps are most liquid at terms shorter than one year, but transactions with longer maturities have increased in recent years. For comprehensive data on recent turnover developments and outstanding FX swaps and cross-currency swaps, see BIS (2007).

A cross-currency basis swap agreement is a contract in which one party borrows one currency from another party and simultaneously lends the same value, at current spot rates, of a second currency to that party. The parties involved in basis swaps tend to be financial institutions, either acting independently or as agents for non-financial corporations. The chart below illustrates the flow of funds involved in a euro/US dollar swap. At the contract's start, A borrows X·S USD from and lends X EUR to B. During the contract term, A receives EUR 3M Libor+ α from and pays USD 3M Libor to B every three months, where α is the price of the basis swap, agreed upon by the counterparties at the start of the contract. When the contract expires, A returns X·S USD to B, and B returns X EUR to A, where S is the same FX spot rate as the contract's start. Though the structure of cross-currency basis swaps differs from FX swaps, the former serves the same economic purpose as the latter, except for the exchange of floating rates during the contract term.

Cross-currency basis swaps have been employed to fund foreign currency investments by financial institutions and their customers, including multinational corporations engaged in foreign direct investment. They have also been used to convert currencies of liabilities, particularly by issuers of bonds denominated in foreign currencies. Most cross-currency basis swaps are long-term, generally ranging between one and 30 years in maturity, mirroring the tenor of the transactions they are meant to fund.