Introduction
In the first post we reviewed the theoretical methods used to calculate a forward FX rate. This was some background to the FX swap product
https://www.fmarketstraining.com/foreign-exchange-swaps-part-1/
Having established the theory lets look at how FX swaps work. An FX swap is a combination transaction which comprises of a spot and forward transaction, both deals done with the same counterparty. It is the largest segment of the FX market accounting for about 55% of daily turnover.
Here is the link to the Bank for International Settlements data. https://data.bis.org/topics/OTC_DER/data
FX swaps – a definition
As the name suggests with an FX swap you are exchanging one currency for another so you may sell GBP for USD spot in the spot market and simultaneously agree that the forward leg would effectively reverse the direction of the cash flows as it would involve the purchase of GBP and the sale of USD.
Rationale
When I first started learning about FX swaps, it struck me that the topic was always taught without much context – “it’s a spot and forward deal” – yeah right. Although there are a number of motivations for doing the transaction, I have found that the easiest way to grasp the significance is to look at it in a different way.
Gold swaps
Suppose I want to borrow some USD for 6 months, but my counterparty will only agree to the transaction if I put up some form of collateral. I decide to use everyone’s favourite asset, gold. I deliver the gold to my counterparty who re-registers the metal into their own name to perfect control and in return I receive my USD. At the end of the loan, I repay the USD loan and get my gold back. I will have to pay interest on the borrowed USD but since they have had use of my gold, I would also want some form of compensation (known as the lease rate in the gold market – another story for another time). As a result the cash flows associated with the final re-exchange will be slightly different than the original transaction.
These “gold swaps” do exist and historically have been used by some European banks as a way of accessing USD funds when counterparties don’t want to touch EUR cash.
FX swaps
So how does this relate to FX swaps? Although we will crunch the numbers in a subsequent post, let us return to our original GBPUSD example. The transaction was:
Spot
Sell GBP
Buy USD
Forward
Buy GBP
Sell USD
The GBP goes out and is then returned (a GBP loan) while the USD comes in and then is subsequently repaid (a USD borrowing). So one way of looking at the transaction is a USD borrowing which is collateralised with GBP.
Tune in next time for more on the mysterious world of FX swaps!