A foreign currency swap is a type of derivative contract that involves exchanging payments in one currency for payments in another currency. The two parties to the swap agree to exchange principal and interest payments on a specified date, with the swap reversing at a later date.
Understanding Forex Swap
Foreign currency swaps are used to hedge against currency risk or to speculate on changes in exchange rates. For example, a company that expects to receive payment in euros in three months’ time may enter into a swap to receive U.S. dollars today and pay back dollars in three months’ time, when the payment is due.
If the euro strengthens against the dollar, the company will save money on the swap. If the euro weakens, the company will pay more. Swaps can be used to hedge against exchange rate risk for both companies and individuals.
The Process of Forex Swap
When two parties enter into a foreign currency swap, they agree to exchange principal and interest payments in one currency for another currency. The swap typically reverses at a later date.
This type of derivative contract can be used to hedge against currency risk or to speculate on changes in exchange rates. For example, if a company expects to receive payment in euros in three months’ time, it may enter into a swap to receive U.S. dollars today and pay back dollars in three months’ time, when the payment is due.
The Different Types of Swaps
There are three types of Forex Swaps – Fixed for Fixed, Fixed for Floating and Forward for Forward.
- Fixed for Fixed – This type of swap is between two counterparties who agree to exchange principal and interest payments on a fixed date, regardless of the currency rate.
- Fixed for Floating – This type of swap is between two counterparties who agree to exchange principal and interest payments based on a pre-determined currency rate, but the terms can be changed at any time.
- Forward for Forward – This type of swap is between two counterparties who agree to exchange principal and interest payments contingent on the future direction of one or more currencies.
When a foreign currency swap is entered into, the parties usually select a pair of currencies in which they will trade. The most popular currency pairs are the U.S. dollar/euro, Japanese yen/euro, British pound/euro, and Brazilian real/U.S. dollar.
Reasons To Use Forex Swaps
There are a few reasons why companies or individuals might choose to enter into a foreign currency swap.
First, swaps can be used to hedge against exchange rate risk. For example, if a company expects to receive payment in euros in three months’ time, it may enter into a swap to receive U.S. dollars today and pay back dollars in three months’ time, when the payment is due. This way, the company can protect itself from the possibility of the euro weakening against the dollar and incurring losses.
Second, swaps can also be used to speculate on changes in exchange rates. If a company believes that the euro is going to strengthen against the dollar, it may enter into a swap in order to take advantage of that expected movement.
Finally, foreign currency swaps can also be used as a way to raise capital. For example, if a company needs euros but only has dollars on hand, it could enter into a swap in which it receives euros upfront in exchange for agreeing to pay back more euros at a later date. This effectively allows the company to borrow euros without having to go through the process of applying for a loan.
