In the forex market, a foreign exchange swap is a two-part or “two-legged” currency transaction used to shift or “swap” the value date for a foreign exchange position to another date, often further out in the future. Read a briefer explanation of the currency swap.
Also, the term “forex swap” can refer to the amount of pips or “swap points” that traders add or subtract from the initial value date’s exchange rate, often the spot rate, to obtain the forward exchange rate when pricing a foreign exchange swap transaction.
How a Forex Swap Transaction Works
In the first leg of a forex swap transaction, a particular quantity of a currency is bought or sold versus another currency at an agreed upon rate on an initial date. This is often called the near date since it is usually the first date to arrive relative to the current date.
In the second leg, the same quantity of currency is then simultaneously sold or bought versus the other currency at a second agreed upon rate on another value date, often called the far date.
This forex swap deal effectively results in no (or very little) net exposure to the prevailing spot rate, since although the first leg opens up spot market risk, the second leg of the swap immediately closes it down.
Forex Swap Points and the Cost of Carry
The forex swap points to a particular value date will be determined mathematically from the overall cost involved when you lend one currency and borrow another during the time period stretching from the spot date until the value date.
This is sometimes called the “cost of carry” or simply the “carry” and will be converted into currency pips in order to be added or subtracted from the spot rate.
The carry can be computed from the number of days from spot until the forward date, plus the prevailing interbank deposit rates for the two currencies to the forward value date.
Generally, the carry will be positive for the party who sells the higher interest rate currency forward and negative for the party who buys the higher interest rate currency forward.
Why Forex Swaps are Used
A foreign exchange swap will often be used when a trader or hedger needs to roll an existing open forex position forward to a future date to avoid or delay the delivery required on the contract. Nevertheless, a forex swap can also be employed to bring the delivery date closer.
As an example, forex traders will often execute “rollovers”, more technically known as tom/next swaps, to extend the value date of what was formerly a spot position entered into one day earlier to the current spot value date. Some retail forex brokers (top list of trusted brokers) will even perform these rollovers automatically for their clients on positions open after 5pm EST.
On the other hand, a corporation might wish to use a forex swap for hedging purposes if they found that an anticipated currency cash flow, which had already been protected with a forward outright contract, was actually going to be delayed for one additional month.
In this case, they could simply roll their existing forward outright contract hedge out one month. They would do this by agreeing to a forex swap in which they closed out the existing near date contract and then opened a new one for the desired date one month further out.