Monday, July 20, 2009


Forex swapFrom Wikipedia, the free encyclopediaJump to: navigation, searchForeign exchangeExchange ratesCurrency bandExchange rateExchange rate regimeFixed exchange rateFloating exchange rateLinked exchange rateMarketsForeign exchange marketFutures exchangeRetail forexProductsCurrencyCurrency futureNon-deliverable forwardForex swapCurrency swapForeign exchange optionSee alsoBureau de changeIn finance, a forex swap (or FX swap) is an over-the-counter short term interest rate derivative instrument. In emerging money markets, forex swaps are usually the first derivative instrument to be traded, ahead of forward rate agreements and before exotics.Contents[hide]* 1 Structure * 2 Uses o 2.1 Funding o 2.2 Hedging o 2.3 Speculation * 3 Pricing * 4 Related instruments * 5 See also[edit] StructureA forex swap consists of two legs:* a spot foreign exchange transaction, and * a forward foreign exchange transaction.These two legs are executed simultaneously for the same quantity, and therefore offset each other.It is also common to trade forward-forward, where both transactions are for (different) forward dates.[edit] UsesForex swaps are used for hedging currency positions and for speculation, but by far and away their most common use is for institutions to fund their foreign exchange balances.[edit] FundingOnce a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency, and a negative (or short) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use tom-next swaps, buying (selling) a foreign amount settling tomorrow, and selling (buying) it back settling the day after.The interest collected or paid every night is referred to as the cost of carry. As currency traders know roughly how much holding a currency position will make or cost on a daily basis, specific trades are put on based on this; these are referred to as carry trades.[edit] HedgingInvestors use forex swaps to hedge their existing forex exposures by swapping temporary surplus funds in one currency into another currency for better use of liquidity. Doing so protects against adverse movements in the forex rate, but favourable moves are renounced.[edit] SpeculationInvestors use forex swaps to speculate on changes in the interest rate differentials between two currencies.[edit] PricingThe relationship between spot and forward is as follows:F = S \left( \frac{1+r_T T}{1+r_B T}\right)where:* F = forward * S = spot * rT = simple interest rate of the term currency * rB = simple interest rate of the base currency * T = tenor (calculated according to the appropriate day count convention)The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:F - S = S \left( \frac{1+r_T T}{1+r_B T} -1 \right) \approx S \left( r_T - r_B \right) Twhere rT and rB are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.[edit] Related instrumentsA forex swap should not be confused with a currency swap, which is a much rarer, long term transaction, governed by a slightly different set of rules.[edit] See also* Currency swap * Overnight index swap * Foreign exchange market * Interest rate swap

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