An FX swap, or currency swap, involves two simultaneous currency purchases, one on the spot rate and the other through a forward contract.
A variety of market participants such as financial institutions and their customers (multinational companies), institutional investors who want to hedge their foreign exchange positions, and speculators use foreign exchange swaps.
FX swaps are designed to hedge against currency risk.
How does an FX swap work?
It is an agreement between two parties to exchange a given amount of one currency for an equal amount of another currency based on the current spot rate.
The two parties will then give back the original amounts swapped at a later date, at a specific forward rate.
The forward rate locks in the exchange rate at which the funds will be swapped in the future while offsetting any possible changes in the interest rates of the respective currencies.
Thus, this creates a hedge for both parties against potential fluctuations in currency exchange rates.
This is what makes forex swaps very useful for multinational and exporting companies.
FX Swap Example
A Japanese firm selling products in the U.S. might want to change U.S. dollars to yen to finance its Japanese operations, but in a month’s time, it will need dollars to pay its American suppliers.
If it changes dollars into yen now and then changes yen back into dollars in a month’s time, the dollar may appreciate against the yen, and the firm will have to pay more yen to obtain the same amount of dollars.
In order to avoid such losses, the company performs an FX swap .
It changes dollars into yen at the spot rate while simultaneously taking out a one-month forward contract for the same amount of yen.
This allows it to repatriate U.S. profits to Japan and to access the dollars it needs to meet its U.S. payment commitments in a month’s time without any currency fluctuations.
Two companies can also perform an FX swap.
A Japanese company needing U.S. dollars, and an American company that wants yen can arrange a currency swap by agreeing on the amount, maturity date, and interest rate for this exchange.