FX Swaps
An FX swap trades one currency for another today and reverses the trade at a fixed rate later, packaging what is really a collateralized loan into a single instrument that never shows up as "borrowing" on a term sheet.
Prerequisites: FX Quoting Conventions, FX Forwards and Forward Points
A pension fund holding euro bonds needs dollars for three months to meet a US obligation, but doesn't want to sell the bonds or take on open-ended dollar exposure. It could sell euros for dollars today and buy them back in three months at a rate fixed right now. Two trades, agreed simultaneously, in opposite directions — that pair is an FX swap, and by far the most-traded FX instrument in the world by notional, well ahead of spot itself.
An FX swap is spot and forward combined into one deal: exchange currencies today, reverse it later at a rate fixed now. Nobody calls it a loan, but posting one currency to get another for a fixed period, then giving it back, is exactly what a collateralized loan does.
The two legs
The near leg is usually spot (or sometimes a forward), exchanging currency A for currency B today. The far leg, agreed at the same instant, reverses that exchange at a later date, at a rate that is not today's spot rate — it's spot adjusted by forward points, which compensate for the interest-rate difference between the two currencies over the period. If currency B pays more interest than currency A, whoever ends up holding B for the interim owes some of that advantage back, and the far-leg rate reflects it.
Worked example
The pension fund sells EUR 50 million for dollars at spot EUR/USD = 1.0800, receiving $54,000,000 today. The 3-month forward is 1.0750 — dollars trade cheaper forward, meaning dollar rates exceed euro rates. In three months the far leg unwinds: the fund delivers back $54,000,000 worth at the new rate, buying EUR 50,232,558 () rather than the original EUR 50 million. The extra euros it pays out are the interest cost of having held dollars for three months, exactly as if it had taken a euro-denominated loan.
What this means in practice
Corporate treasurers roll FX swaps to fund foreign subsidiaries without touching the local loan market, banks use them to manage currency mismatches between assets and liabilities overnight, and hedge funds use them to finance carry positions. Because the swap points embed an implied interest rate, a trader can read a swap quote and immediately tell whether funding a currency synthetically through the swap market is cheaper or more expensive than borrowing it outright — the subject of the FX-Swap-Implied Yields and Synthetic Funding page.
If you can't remember which leg is which, remember "near" and "far" describe time, not size — near leg is closer to today, far leg is the later reversal, and only the far leg's rate carries the interest-rate information.
Related concepts
Practice in interviews
Further reading
- BIS Quarterly Review, 'The Dollar-Trillion FX Swap Market'
- Weithers, Foreign Exchange: A Practical Guide to the FX Markets (ch. 8)