Forex swap refers to an agreement to barter a stipulated amount of one country’s currency for another. The Forex swapping is done at one or more future dates. Typically it can also be said that a foreign exchange swap is actually the simultaneous purchase and sale of one currency for another one with two different value dates. In this process the two concerned parties agree for a currency exchange on one day and simultaneously they agree to reverse the deal on a future date. Hence, for a specific time both the parties are allowed for the use of an amount of foreign currency. The price of a Forex swap is quoted in the forward points. Forex swap is different from currency swap.
In case of the Forex swap, a spot foreign exchange transaction is made at a point of time and at the same time forward foreign exchange transaction is done for the same quantity. The forward transaction is actually the reverse of the spot transaction, where the spot purchase is equivalently compensated by a forward selling.
In other way, the Forex swap may also be referred as the over-the-counter short-term interest rate derivative instrument. In the present day money markets, forex swaps are usually considered to be the first derivative instrument to be traded that is even ahead of forward rate agreements. The Forex swaps are usually used for hedging or speculation.
The investors in the Forex market use the Forex swaps in order to hedge their existing Forex exposures by swapping the temporary surplus funds in one currency into another currency. This ensures them for the better use of liquidity. This move by the investors protects them against adverse movements in the Forex rate. The investors in Forex market use the Forex swap in order to speculate the changes occurred in the differentials of interest rates between two currencies.
The following formula describes the relation between the spot and forward:
F = S ((1+ rTT)/(1+rBT))
F refers to Forward
S refers to Spot
rT refers to the term currency interest rate
rB refers to the base currency interest rate
T refers to tenor, which is determined by the appropriate day count convention
Last Updated on : 1st July 2013