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FX Swaps

September 6, 2022
Understanding forex swaps

What are swaps in forex? A swap in forex trading occurs when two parties opt to loan one another an amount of a specific currency. Party A will loan a designated amount of one currency to Party B, and Party B will loan an equivalent amount of a different currency back to Party A. Both parties will pay interest on the amount of currency they have received.

Each party will need to agree on an exchange rate. This is based on the current forex spot trading rate — i.e., the exchange rate at the present moment — but the final agreed amount is likely to be above this value, factoring in predicted changes throughout the trade.

The actual loan amount does not necessarily need to change hands during a forex swap. While an agreed principal amount will be used to derive the interest that needs to be paid on the loan, this principal amount may not need to be transferred between the two parties. 

Generally, if the principal is not transferred, the forex swap will be a ‘fixed for floating’ swap. This means the two parties will pay interest based on the currency’s actual interest rate. The interest rate can increase or decrease over time, affecting the amount the recipient of the currency needs to pay.

In other cases, however, the full principal amount will be exchanged, and interest will be paid on top of this. At the end of the swap agreement, the exchange of the principal will be reversed, and each party will have their initial currency value returned to them.

When the principal amount changes hands, this is usually executed as a ‘fixed rate’ swap. Interest rates are paid at the levels that apply at the beginning of the swap agreement. This rate does not change, and interest is paid at this consistent level for the entire exchange duration.

Forex swaps and leverage

Leverage in forex is something that traders need to be aware of, as it is a significant part of the market process. This concept involves borrowing additional funds via a brokerage platform, which are then used to supplement the trader’s capital reserves. 

Trading leverage is represented as a ratio. A leverage ratio of 20:1 means that the trader is borrowing $20 for every $1 of their own capital they use to open the position. This allows traders to control a position 20x the value their own capital would otherwise allow — translating to 20x the profits if the trade is successful. Movements in currency prices are measured in pips. A pip in FX is an incremental move at the fourth decimal place of the currency value or the second decimal place in the case of smaller denomination currencies such as the Japanese Yen. These single pip movements are minimal, so the trader does not stand to gain or lose much from each one — with leverage; however, these movements are magnified by the order of the leverage ratio.

The loan amount will need to be paid back — plus interest — regardless of whether or not the transaction is successful. This is why traders need to be very careful with leverage, as their losses can be significant.

Traders cannot use leverage when they carry out a forex swap. Leverage is used for other types of trading, usually when opening buying or selling positions on currency pairs in the hope of a profit. Instead, leverage relates to FX swaps in a different way. When traders use leverage, they expose themselves to the swap interest rate. This is because they are borrowing capital to supplement the trade, and this borrowed capital carries an interest rate, as mentioned above. Users pay interest on their leveraged trade in the same way swap traders pay interest on the capital they receive.

Differences between forex swaps and other forex derivatives

You can view an FX swap can as a forex derivative. This is because the value of the swap agreement is derived from underlying data taken from the foreign exchange market. There are several other types of derivatives that traders can choose from as they learn more about the forex market, and swaps are different to these derivative types in many ways.

  • FX swaps and FX futures

An FX future is a contract to carry out a transaction at a predetermined time. For the duration of the contract, the exchange rate is locked in and cannot move up or down — similar to the way an interest rate may be locked in with regard to a fixed rate swap. However, the transaction is not executed at the beginning of the trade but is completed at the end of the contract period, making swaps and futures fundamentally different. 

  • FX swaps and FX forwards

An FX forward contract is very similar to a future contract. Both involve locked-in exchange rates and set time periods. The difference between the two derivatives is that futures are standardised contracts sold over an exchange, while forwards are not standardised and sold over the counter (OTC) via a brokerage. This means you can customise the terms of a forward to meet specific needs. As the transaction is incomplete until the end of the contract period, forwards are also inherently different to swaps.

  • FX swaps and FX options

FX options feature locked-in rates and predefined contract periods like forwards and futures. The transaction is not completed until the end of the contract period — a primary difference between FX swaps and options derivatives. Unlike forwards and futures, options do not carry an obligation to complete the transaction.

The benefits of forex swaps

What are the benefits of forex swaps? What do traders get out of completing this sort of transaction? Read on to discover more about the advantages of this type of foreign exchange transaction.

Access to foreign capital

In the most basic sense, a forex swap enables traders to access foreign capital they may need for business purposes. If a trader wants to invest in a foreign market, they may need to exchange their domestic currency resources to gain access to the capital they need. This means paying the associated fees, which can be high, particularly when a large amount of capital is exchanged.

With a forex swap, traders may be able to access the capital they require in a more manageable and cost-effective manner. This may provide a more effective platform for foreign investment and business dealings than other sorts of currency exchange. However, this requires a strategic approach, careful calculation, and accurate forecasting for the future of the forex market. Even with all these measures in place, there are no guarantees that the strategy will be successful.

Ability to borrow at a better interest rate

With a swap in the forex market, traders will pay an interest rate based on the currency they receive as part of the exchange. In the case of a fixed rate swap, this interest rate will be locked in for the duration of the exchange contract, while a fixed to floating rate will fluctuate along with the interest rates applied to the foreign currency. In some cases, this interest rate may be more attractive to the trader than those involved in their domestic currency.

With the fixed rate swap, there is no risk of the interest rate changing over time, and the calculation is more straightforward. With fixed to floating swaps, however, the calculation becomes more complex as the trader must carefully forecast and predict future changes in the foreign currency’s interest rate.

Speculation capabilities

Traders may use forex swaps to speculate on relative price movements between currencies. Once a quote currency value is agreed upon, this value is set in the terms of the contract. When the contract reaches maturity, the exchange is reversed. If the quote currency value has moved above the predetermined exchange rate, the party who put up the quote currency initially makes a profit. If the quote currency value has fallen below the predetermined exchange rate, they will make a loss.

A range of different choices

Traders have a wide range of choices when they approach a forex swap. There are over 180 currencies listed on the foreign exchange market, and any of these currencies can be offered up in a trade. While most currency pair trades are made on pairs involving the same major currencies — including the United States Dollar and the European Euro — swaps can be made with any listed currency, provided the parties can agree on a rate of exchange.

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