FX swaps, which are also referred to as foreign exchange or forex swaps, are commonly used by businesses that need to invest money in a foreign currency. With an FX swap, a business will simultaneously purchase and sell a certain amount of foreign currency.
The system of an FX swap allows a business to invest money in a foreign currency over a period of time without being affected by fluctuations in the exchange rate.
By purchasing and selling the currency using a spot and forward trade (as is most common), the company avoids being affected by fluctuations in the exchange rate. The amount of foreign currency that is bought at the outset will effectively be returned at the same exchange rate at a future date. Therefore, normal changes to the exchange rate will not have to be taken into account.
Usually, the foreign currency that is needed for overseas investment is bought at the spot rate. This is the current market rate that is immediately available when the company carries out its FX swap. Simultaneously, the company will agree to exchange the same amount of foreign currency back into its domestic currency on a future date at the forward rate. This future exchange is set in place with a contractual agreement set out in a forward trade deal.
The forward rate is the current spot rate adjusted to take the interest rate of each currency into account, and the forward trade will be set to take place on or before a future date. Forward rates are designed to be a future reflection of the current exchange rate with only the effect of interest rates being taken into account.
While forward rates are available, real exchange rates vary according to a huge number of factors and can change very differently from what is predicted by a forward rate. It may be that when the time comes to repatriate the funds from overseas, the spot rate is actually significantly unfavourable. By having a set forward rate, the company avoids this risk.
The system behind an FX swap can be thought of as a way of exchanging at the spot rate now and then again in the future. It allows funds to be directed overseas without the risk of a change to the exchange rate negatively impacting what is received when those funds are repaid. Without the security of a forward exchange rate, a business is exposed to the risk that a change in the exchange rate will cause them to lose money.
The immediately available spot and forward rates are in effect the same exchange rate.
While it is true that FX swaps are often carried out with a spot rate and a forward trade, they can also be carried out with two forward trades. In this case, the same system is effectively just moved forward to a future date.
FX swaps can be done with financial derivatives or by entering into an agreement with a foreign counterparty. When carrying out an FX swap with derivatives, a business could approach a currency broker or another organisation that offers financial products like spot and forward trades. They simply then take out a spot and a forward trade or two forward trades with that organisation to complete an FX swap.
Alternatively, and as is often done, a company can find a counterparty in the foreign currency it is investing in with which it will agree to swap funds. The two parties then swap funds at a spot rate and simultaneously agree on a forward rate at which they will repatriate each other’s funds.
As an example, a business from the UK which is looking to invest in the USA over a period of six months may attempt to avoid the risk of money that they convert into US dollars converting back into less in British pounds after the six month period because of an adverse change to the exchange rate.
If they were looking to invest 20,000,000 USD, for example, this an investment of 16,000,000 GBP at an exchange rate of 0.80 USD/GBP. If the company simply invests this money and waits for six months to then repay it at the spot rate, they risk being affected by an adverse change to the exchange rate. If, for example, the exchange rate changes to 0.75 USD/GBP in that time, when they repatriate their funds they will only receive 15,000,000 GBP.
To protect themselves against this risk, the company can set up an FX swap. To do so, they can find a currency broker or a bank which will agree to set up a forward trade with them. As we have explained, this is an agreement to exchange currencies at a set rate on or before a future date. The company then simultaneously exchanges the funds they are investing in at the spot rate and agree to repatriate it at the rate set in the forward trade.
The pre-agreed forward rate in this instance might be something like 0.7994. This is the spot rate adjusted to take into account the effect that the domestic interest rate of each currency has on its value in relation to the other currency over time.
After the six-month period is over, the company then reconverts its USD investment back into GBP with the forward trade and is not affected by any unexpected changes to the exchange rate. In this instance, the company receives 15,988,000 GBP from its original investment.
In this example, the company will have saved almost one million GBP by hedging against the risk of the exchange rate changing with their FX swap.
While the example above gives a basic explanation of how an FX swap works, they can be used in various ways. By varying the specific conditions of an FX swap, including the dates of repayment, the parties involved, and other factors, a number of outcomes can be achieved.
Nonetheless, the central reasons that an organisation would use an FX swap are to provide a way of accessing foreign currencies without being exposed to risk from fluctuating exchange rates.
Essentially currency swaps and FX swaps serve the same economic purpose, in that they allow a company to have access to funds in a foreign currency. The difference is that currency swaps specifically take place between two parties and those parties exchange interest rates as a means to access cheaper foreign currency borrowing opportunities.
With an FX swap, interest rates for repayment are not exchanged and the arrangement is specifically designed to allow access to foreign currencies while hedging against the risk of being exposed to exchange rate fluctuations. While the same risk can be hedged against in the process of completing a currency swap, this is not necessarily a specific aim.
The way that currency swaps and FX swaps are applied in practice also differs significantly. FX swaps are often used during shorter-term investments and are used by businesses of varying sizes. Currency swaps tend to be used for longer time periods and by larger organisations, such as governments or large multinational corporations.
Bound specialises in FX hedging. FX hedging is what companies do to protect themselves against losing money to exchange rate fluctuations while they are trading in foreign currencies.
On the Bound platform, a business that is looking to invest funds in a foreign currency could carry out an FX swap. Both spot and forward trades are available on the Bound platform and can be completed with significant ease, allowing a business to arrange an FX swap in the most convenient and transparent way possible.