Forex Trading

Foreign Currency FX Swap: Definition, How It Works, and Types

See also Aldasoro et al (2017) for evidence of differential pricing in dollar funding markets; Japanese banks pay a premium to borrow via repos from US money market funds. 8 Only 1% of FX transactions are centrally cleared (Wooldridge (2017)), and most of those remain limited to non-deliverable forwards (McCauley and Shu (2016)). At end-2007, before interest rate swaps were centrally cleared, the inter-dealer share of such positions stood at almost 40%. Finally, currency swaps have limited liquidity, which makes it difficult to enter or exit a swap agreement at a favorable rate. Also, given the complexity of currency swaps, some financial institutions may find it difficult to use them effectively. The most common[citation needed] use of foreign exchange swaps is for institutions to fund their foreign exchange balances.

In addition to hedging exchange rate risk, this type of swap often helps borrowers obtain lower interest rates than they could get if they needed to borrow directly in a foreign market. Once a foreign exchange transaction settles, the holder is left with a positive (or “long”) position in one currency and a negative (or “short”) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day.

To be sure, the investor may deal with different counterparties and face different operational issues. And, if market prices are not perfectly aligned, one strategy may pay off better than the others. In each case, the investor takes on foreign currency debt – in the form of a forward (case 1), the forward leg of the FX swap (case 2) or the amount borrowed in the cash repo market (case 3). And, in each, the investor must pay foreign currency to settle the maturing debt. Currency swaps are financial contracts between two parties to exchange a specific amount of one currency for an equivalent amount of another currency. The purpose of currency swaps is to reduce currency risk, achieve lower financing costs, or gain access to a foreign currency.

  1. Once a foreign exchange transaction settles, the holder is left with a positive (or “long”) position in one currency and a negative (or “short”) position in another.
  2. The forward rate is the exchange rate on a future transaction, determined between the parties, and is usually based on the expectations of the relative appreciation/depreciation of the currencies.
  3. We use the apparent currency mismatches visible on-balance sheet to infer the amounts of swaps and forwards.
  4. Many leveraged accounts (eg Commodity Trading Advisor funds) sell dollars in the futures market rather than in the OTC market.
  5. The table shows the corresponding balance sheets, with the subscript X denoting foreign currency positions.

One purpose of engaging in a currency swap is to procure loans in foreign currency at more favorable interest rates than might be available borrowing directly in a foreign market. Foreign exchange swaps and cross currency swaps are very similar and are often mistaken as synonyms. The parties swap amounts of the same value in their respective currencies at the spot rate. As a rule, prudential regulation generally follows accounting, with first-order implications for the treatment of FX swaps/forwards. While the corresponding cash flows are captured and treated equivalently in liquidity regulation, the picture is quite different for the leverage ratio in particular.

US non-banks have sold only $600 billion in non-dollar-denominated debt to non-residents (US Treasury et al (2016)). Many leveraged accounts (eg Commodity Trading Advisor funds) sell dollars in the futures market rather than in the OTC market. 22 This also assumes that dealers – and not customers – have matched positions in which the dollar serves as the vehicle currency, eg a swap from yen to dollars matched with one from dollars to euros. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity.

FX swaps, regulation, and financial stability

Just as for the case of the $10.7 trillion worth of on-balance sheet debt, this additional dollar debt contracted through FX derivatives is to some extent supported by dollar revenues and/or assets, ie currency-matched. The previous analysis suggests that the whole amount of that debt could be rationalised by hedging activity, be it trade or asset holdings. Such hedging can support financial what is the difference between data and information with examples stability, especially if maturities are matched. Experience shows that FX derivatives can also be used to take open positions, including in the form of carry trades. And off-balance sheet debt can cause or amplify strains, especially in the case of FX options (which are beyond the scope of this analysis). The available statistics do not allow us to identify the extent of speculative use.

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Also, instead of using currency swaps, companies can use natural hedges to manage currency risk. Finally, companies can choose to remain in their domestic market and avoid foreign currency transactions altogether, eliminating the need for currency swaps or other hedging strategies. This feature revisits Borio et al (2017), drawing on the comprehensive data in the 2022 BIS Triennial Survey.

First, it updates the stylised facts concerning FX swaps/forwards and currency swaps. Second, it measures the missing dollar debt for non-banks resident outside the United States, and for banks headquartered outside the United States. This off-balance sheet dollar debt poses particular policy challenges because standard debt statistics miss it. The lack of direct information makes it harder for policymakers to anticipate the scale and geography of dollar rollover needs. Thus, in times of crisis, policies to restore the smooth flow of short-term dollars in the financial system (eg central bank swap lines) are set in a fog. 20 In some cases, the authorities finance some foreign exchange reserves by swapping domestic currency into dollars.

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The bottom panels of Graph 5 show aggregates for the non-US banks that, on net, lend dollars through FX swaps in order to square their books. Thus, one can relate non-financial FX swaps/forwards and currency swaps, in an admittedly stylised fashion, to international trade and bond issuance, respectively (Table 1). If firms use $5.1 trillion of short-term FX forwards to hedge global trade of $21 trillion, then the ratio implies that importers and exporters hedge at most three months’ trade.

11 Institutional investors’ hedging practice can be defended for equities, which vary in price and have no maturity (D’Arcy et al (2009)). Melvin and Prins (2015) describe equity investors’ common practice of adjusting their hedges on the last day of the month at the widely used 4 pm London “fix”. 3 Dealers maintain the secured nature by agreeing to credit support annexes. The mark-to-market loser regularly hands over cash or securities (“variation margin”) to the mark-to-market winner.

These positions should sum to zero for each banking system but often do not. Fourth, non-bank private sector entities can provide hundreds of billions of dollars. In June 2014, the then largest US bond fund, PIMCO’s Total Return Fund, reported $101 billion in currency forwards, no less than 45% of its net assets (Kreicher and McCauley (2016)).

When the Great Financial Crisis (GFC) broke out, the FX swap market came under substantial strain (Baba et al. 2009, McGuire and von Peter 2009), as funding in the wholesale unsecured segment froze. The extent of the strains took many by surprise, as did the underlying demand for US dollars, especially as this came from European banks. Had the amount of FX swaps and the banks in need been more broadly known, the surge would have been less unpredictable or at least more easily understood. The funding disruptions were so serious that they prompted major central banks to put in place FX swap arrangements to channel the necessary US dollar funding to those that needed it most. 17 BIS data provide only a partial picture of the dollar books of banks headquartered in China, Korea, Russia and many other countries. An aggregation of these banks’ observed dollar positions, however, suggests that they are, overall, net borrowers of dollars via FX swaps, pointing to an even wider gap than shown in Graph 6.