Currency Swap - A Simultaneous Spot and Forward Transaction

A swap transaction is a simultaneous forex spot purchase or sale transaction together with a forex forward purchase or sale transaction. In the forex market a swap transaction is sometimes referred to as a sell and buy, or a buy and sell.

Let’s look at a typical swap transaction. On January 5^th a trader enters into a $/Yen swap transaction (90-80) and buys $1,000,000 at 99.80 and at the same time agrees to sell $1,000,000 at 98.90 (spot 99.80 - 90 swap points) one month later on February 5^th. Let’s look at the cash flows for this transaction.

One of the main features of a swap transaction is that there is no currency exposure as the spot transaction exactly matches the opposite forward transaction.

This is because if the spot rate moves from 99.80 to 99.60 the forward leg of the currency swap will move in tandum so as to keep the 90 swap points differential which reflects the interest rate differential between the dollar and the Yen.

Spot $/Yen 99.80 -90 swap points forward rate $/Yen 98.90

Spot $/Yen 98.90 -90 swap points forward rate $/Yen 98.00

The $/Yen interest rate differential remains the same and there is no currency exposure.

£/$ spot rate is 1.3340 - 1.3345 and a corporate treasurer calls a bank and asks for a £/$ one month swap quote. The bank quotes 130-120 one month swap rate. Notice that the swap rate is quoted exactly the same as a one month forward rate. The corporate treasurer wants to buy and sell sterling for one month. As he is selling sterling forward he would take the bank's bid rate of 130 swap points. Now for the buy side of the transaction the bank would normally use a mid rate between the bid and offer spot rate. As we discussed before as long as the difference between the spot rate and the forward rate is the quoted swap points, in this case 130 swap points, it doesn't matter where the level of the spot rate is.

So the corporate treasurer has sold sterling at 130 swap points one month forward. What is the outright forward rate? If you recall from my hub on forward rates if the quoted forward points as in this (130-120) case are descending from left to right then the base currency, in this case the sterling, is at a discount forward (sterling interest rates will be higher than dollar interest rates) and the points are deducted from the spot rate. If the forward points ascend from left to right the points are added to the spot rate.

Let's look at the cash flows in this example and assume that the corporate treasurer wants to buy £1,000,000 and sell £1,000,000 on the forward leg of the swap.

There are four main reasons why a company might want to do a currency swap. The first and most likely one is to speculate on a change in interest differentials. For example a corporate treasurer might have sterling investments or assets and have dollar liabilities. The treasurer might feel that the interest differential between the Uk and the USA might narrow over the next month. The company might want do a one month swap and sell the sterling at spot and buy it back forward.

£/$ swap quotes = spot 1.3350-60 and one month forward 150 - 140

The company sells £15,000,000 at 1.3355 spot and buys $20,032,500

The company buys £15,000,000 at 1.3215 forward and sells $19,822,500

Let's assume that during the day the UK interest rates were lower. The company asks its bank for a one month currency swap quote. The bank quotes 110-100 showing that interest rates had narrowed. The company then does an opposit swap and buys sterling at spot and sells the sterling forward at 110 swap points. Let's look at all the cash flows assuming the spot rate is around 1.3350. From the table below you will see that the company makes $45,000 profit on the back to back currency swaps.

A company might find it easier to borrow dollars offshore for a three month period rather than in its domestic market. Borrowing dollars using a swap transaction allows them to do this without incurring any currency risk. In essence they would buy the dollars they needed at spot and sell them three months forward.

A UK company has contracted to buy goods at a certain date from Japan paying for the goods in yen. For some reason the shipment is delayed for a few weeks and the company does not want to sit on its yen as it will have a currency exposure. So it can enter into a currency swap and sell the Yen at spot for sterling and buy the yen back again when they need them. In this way the company does not have any currency exposure.

When a company takes a view on the future interest differentials between two currencies they can use currency swaps for a forward against forward transaction. This is a form of interest arbitrage. The forward against forward transaction involves a buy/sell or sell/buy swap for one maturing and an opposite swap for a different maturity. This is how the cash flows might look assuming a $/Yen forward against forward transaction.

January 18th Spot +$1M - Yen 99,500,000 at 99.50

February 18th Forward -$1MM + Yen 98,900,000 at 98.90

January 18th Spot -$1M + Yen 99,600,000 at 99.60

April 19th Forward +$1M - Yen 98,100,000 at 98.10

Making a profit of Yen 900,000 (approx $9,000) on the forward against forward transaction.