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As you gain experience trading the forex market, you will come across an increasing number of terms. One such term is a currency swap. These kind of transactions actually make up for a large amount of the volume traded on the markets, and they are commonly applied in a few situations when you are trading forex. Here we will explain in more detail exactly what currency swaps are, how they usually occur, and why they can be beneficial to certain types of traders in the sector.
Basics of a Currency Swap
In the most simple of terms, a currency swap does exactly as the name implies. It is an exchange of currency between two parties of the equivalent amount of money in another currency. There is then a contract in place to repay this money at a specified date, and exchange rate in the future. In essence, this is a currency swap. A currency swap can bear some similarity to that of currency futures, though they differ in the sense that they are held until settlement, and considered to be a large part of forex trading, whereas currency futures are traded on other exchanges.
Currency Swap Example:
Party A, and Party B enter an agreement to swap €1,000,000 for $1,150,000. This fills the need for the counter currency for both parties, and creates an implied EUR/USD exchange rate of $1.15.
The transaction is then completed at a future defined date, using either the original exchange rate of $1.15, or another agreed upon exchange rate. Essentially, the two parties are loaning a particular foreign currency to each other. In some cases with currency swaps, this can include the payment of interest or principal amounts on loans, though this will depend on the details of the individual agreement.
Who Engages in Currency Swaps?
Currency swaps used to be the preserve of those in countries where the foreign exchange rates were extremely volatile, or as where they could be used as a mechanism to overcome currency restrictions.
While this is still the case on a more limited basis, the use of currency swaps has increased around the world as investors and companies become increasingly multinational. Here are a couple of examples of where currency swaps are most often used to good impact in today’s forex market.
Companies Doing Business Abroad: Currency swaps may be particularly beneficial to businesses who have interests abroad and need to borrow in order to conduct this business. They may not necessarily benefit from favorable loan terms from banks outside their home country. Therefore, if they can borrow money in their home country at the best terms, and conduct a currency swap with a similar company in the country they are seeking to invest, then this trade could be of benefit to all involved.
Volatile Currencies: A currency swap may be beneficial, an almost essential in some cases, for institutional and retail investors in nations where the local currency is known to be volatile. This is one of the main purposes behind engaging in a currency swap, to guard against currency risk with more volatile currencies. By engaging in a currency swap, both parties can set the terms, and have a certainty around the cost of their trade.
As we can see with these examples, currency swaps are most often used by companies, and other types of institutional investors. This is certainly a more common situation than the use of currency swaps by retail investors, although in some situations, retail forex traders can be impacted.
Risks Involved in Currency Swaps
While currency swaps can be beneficial in the most part for the points noted above, just like any form of trading, they are not completely without risk. If you are engaging in a currency swap, here are a couple of the primary risks you can expect to encounter.
Interest Rate Fluctuation: One of the main purposes of engaging in a currency swap may be to take advantage of better interest rates in the currency that you are borrowing as part of the deal. These interest rates though are often left floating in contracts. Therefore, there is a chance that a change in the exchange rate could negate any of the cost-saving benefits you hoped to derive from the currency swap in the first instance.
Exchange Rates: With currency swaps, perhaps the most important element is the exchange rate. This is often pre-defined within the swap contract to be a set rate at the future time when the deal reaches maturity. Here again, there is a chance that the future rate is worse for one party than the original or current rate. In this case, there may be a slight loss on the swap.
Forex Trading Swap Fees
The term swap fee, or forex swap is something you will also encounter if you are an online forex trader. This can also be known as the overnight fee, or rollover fee, and may sometimes be confused with the currency swap.
This is a “fee”, though it can be either positive, or negative, that is applied to positions you hold open overnight when trading through your forex broker. This amount is constantly changing, and basically represents the difference in interest rates on the currency pair which you are holding. Therefore, holding a long position in certain currency pairs will see you credited with the positive interest difference, while short positions will see this fee deducted from your balance.
Although it is typically an area of more concern for more experienced, and institutional traders, the currency swap still plays a huge role in forex trading overall, and is a very useful trade to be aware of. This is particularly true if you are looking for one of the most secure ways to deal in a large amount of foreign currency and in a situation where you wish to add some degree of security or control to the trade over a long period of time.
Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.