Foreign Exchange Swaps/FX Swaps - Currency Swaps

Do you really have any idea of what Foreign Exchange Swaps are? Foreign Exchange Swaps are a brilliant way to profit the markets nowadays if you know how to use it. The average retail traders most probably know how and when to take advantage of swaps.

FX Swaps VS Foreign Currency Swaps

Stick around, and I will explain to you how to do it accurately. I’ll explain to you the difference between FX Swaps vs foreign Currency Swaps. Well, some investors assume foreign exchange swaps as similar to the foreign currency swaps, and both terms considered to use interchangeably. Even though both of the terms are derived instruments used for covering foreign currency exposure. In addition, each one of them has different features, which makes a distinction and make them appropriate for various purposes that depends on the investment perspective or risk profile of the investor.

Foreign exchange swaps are the most straightforward kind of currency swap. Foreign exchange swaps considered as an agreement between two parties to exchange an amount of money in one currency for an equal amount of a different currency; Based on the present spot rate. These two parties will return the original amounts swapped later, at a precise forward rate.

foreign exchange swaps

The forward rate locks in the rate of exchange at which the money will swap in the future; while offsetting possible changes in the respective currencies’ interest rates. Therefore, this creates a hedge for both the parties against possible currency exchange rate fluctuations. It makes foreign currency swaps very useful for multinational companies and exporting companies.

Moreover, being derived instruments that are used for hedging, here are some of the similarities of Fx swaps vs currency swaps, which include;

Similarities of FX Swaps VS Foreign Currency Swaps

  • The exchange of two distinctive currencies at the beginning and turnaround of the same currencies at the end of the agreement are involved in Fx swaps as well as foreign currency swaps.
  • Both instruments need no opening expense as they are agreements and have an initial value of zero.
  • Both swaps the foreign exchange and currency are susceptible to counterparty risks as they are OTC instruments, which negotiate in private. They also lack the transparency that futures control, as they are not typically entered into, on a structured exchange.

Let us analyze the different features and possible applications of both instruments separately.

FX Swaps

Just like foreign currency swaps, Foreign exchange swaps known as imitative instruments that are used to hedge against unfavourable movements in foreign currency positions. However, you’ll see a difference among Fx swaps vs currency swaps, in terms of currencies are exchanged. Usually, Fx swaps have two legs; “near leg” is the first leg, which includes buying or selling of one currency in opposition with another currency at a spot rate. And the second leg is the “far leg,” which includes turning around the exchange route of both currencies at the completion of the swap by using a forward rate.

In the short term, it considered as ordinary to use Fx swaps to alleviate currency fluctuations. Moreover, they provide two key purposes:

  • To turn over, promote contracts upon ending if the investor plans to keep a hedged position.
  • To modify sizes of forwarding contract positions if the value of the hedged revelation is expected to boost or reduce.

Do you really have any idea about what foreign currency swaps are in reality? Well, let’s start with a simple explanation.

foreign exchange swaps

Foreign Currency Swaps

These counts as frequently used imitative instruments on the medium to long term by global investors, polygonal corporations, banks, institutional investors, etc. And these also used to hedge in opposition of unfavourable currency movement and to minimize borrowing costs efficiently. It requires the exchange of theoretical principals of two distinctive currencies by two companies. At the start and at the end of the contract while paying or receiving temporary cash flows in between at a steady or preset rate. For instance, at the beginning of the contract, Party A has spent 300 million nairas to another Party B. Whereas Party B has paid 1 million dollars to Party A. While ending the contract, Party B has returned 300 million nairas to Party A whereas Party A returned 1 million dollars to Party B.

As alluded to above, a distinct feature of foreign currency swaps is the payments made in-between by both parties on the currency each party received at the start of the agreement. E.g., Party X pays 3% on 1 million dollars periodically to Party Y while Party Y pays 10% of 300 million nairas regularly to Party X.

Well, the periodic payments could be floating or fixed. At the beginning of the contract period, it will be determined if any of the parties agree to pay at a fixed rate by using domestic interest rates such as LIBOR in London or anything equivalent to it in other countries. Pricing is the process of determining the fixed rate.

foreign exchange swap

Parties that are involved in currency swaps usually are of good credit quality. Here is another example that may help you to understand:

Blue Tops Plc

A Nigerian bank tends to start operations in South Africa. And, for this reason, 500 million SA Rands required to fund this expansion. Blue tops in South Africa is unknown, and that’s why it will attract comparatively high lending rates to compensate for credit risk and to decide to take a loan.

In the same way, investors will demand a high-interest rate. And Blue tops should attempt to issue bonds in South Africa. However, a South African based international swap dealer, which is Gold Line Bank who is familiar with Blue tops can offer a 5-year swap deal. By which, at initiation Gold line bank pays the mandatory 500million Rands. And it offers 5% to Blue tops and gets 13 billion nairas in return at 6%. On the notional principals, semiannual payments are made as well. In Nigeria, Blue tops might decide to issue bonds of worth 13 billion Naira. And it will become a deal at a low-interest rate to fund the swap deal.

Foreign Exchange Swaps for International Businesses

A European firm in the U.S. selling products may want to change U.S. dollars to euros to finance the European operations. However, within a month, it will require dollars to pay its American suppliers. If that firm changes dollars into Euros at the time, and within a month, it changes Euro back into dollars, the dollar may value against the Euro and the firm ought to pay more Euros to get the same amount of dollars.

To avoid such high losses, the company can have FX swaps. It helps to change dollars into Euros at the spot rate. Whereas at the same time can take out a one-month forward contract for the same amount of Euros. It let the U.S. profits send back to the EU. And to access the dollars it needs to meet the U.S. payment commitments in a short time of one month without facing any currency fluctuations.

Hence two companies can perform a currency swap. An American company that needs Euros and a European company that needs U.S. dollars can place a currency swap. And this swap will take place with some mutual amount agreement, along with maturity date and interest rate for this swap.

foreign exchange swaps

Foreign Exchange Swaps Explanation

The main drive for engaging in a foreign currency swap is often to obtain loans in foreign currency at more appealing interest rates than borrowing in an international market directly. The first time currency swaps came in 1981 by the World Bank. This was an effort to obtain Swiss francs and German Marks. Such kind of swaps can take place on loans with maturities that are up to even ten years. Foreign exchange swaps are different from interest rate swaps because they also involve significant exchanges.

In a foreign currency swap, both parties continue to pay interest on the swapped principal sums all through the length of the loan. At the end of the swap, exchanging principal amounts occurs once again at a pre-agreed rate or the spot rate.

foreign exchange swaps explanation

Additionally

Besides being derivative instruments utilized for hedging; other similarities of Fx swaps vs Foreign Currency swaps include;

  • Foreign exchange swaps and Currency swaps have to do with the exchange of two different currencies; at the beginning and reversal of the same currencies at the end of the contract.
  • Currency swaps and foreign exchange swaps are both agreements. And that requires no initial expense because both of them have an initial market value of zero.

Final Thoughts

While recapping, both Fx swaps and foreign currency swaps are imitative instruments used for hedging in opposition to unpleasant exchange rate variation. However, usually, Fx swaps employed for a shorter period. For example under 1 year and used to turn over forward contracts and to adjust available forward contract sizes. On the other hand, Currency swaps often used for medium to a long-term period. For example, 2 years and typically are efficient for reducing the costs of borrowing.

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