Forex swap

In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward)

By far and away the most common use of FX swaps is for institutions to fund their foreign exchange balances.

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 do this they typically use tom-next swaps, buying (selling) a foreign amount settling tomorrow, and selling (buying) it back settling the day after.

The interest collected or paid every night is referred to as the cost of carry. As currency traders know roughly how much holding a currency position will make or cost on a daily basis, specific trades are put on based on this; these are referred to as carry trades.

Pricing:

The relationship between spot and forward is as follows:

where:

• F = forward rate
• S = spot rate
• r₁ = simple interest rate of the term currency
• r₂ = simple interest rate of the base currency
• T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is expressed as the following:

where r₁ and r₂ are small. Thus, the absolute value of the swap points increases when the interest rate differential gets larger, and vice versa.