A swap transaction in the foreign exchange market is the simultaneous purchase and sale of a given amount of currency for two different value dates. The most common foreign exchange swap (FOREX swap) is a spot against forward swap. Financial institutions, multi-national corporations and other businesses use swaps to help hedge their investments against unfavorable fluctuations in the value of foreign currency.
Investors and institutions use foreign exchange swaps to help protect themselves from the volatility in the foreign exchange market. For example, if a United States company that currently has business in Europe may use swap agreements to hedge against the depreciation of the Euro. In addition, some speculators use swaps to place bets on the movement of a currency.
Spot Against Forward Swap
A spot against forward swap is the most common foreign exchange swap. In a spot against forward swap, a dealer will buy a currency in the spot market and simultaneously sell the same amount back to the bank in the forward market. As a result, the deal eliminates foreign exchange risk by guaranteeing the forward rate.
Forward Against Forward Swap
A forward against forward swap uses two forward contracts to borrow currency without foreign exchange risk. For example, a dealer will sell 1,000 pounds forward for dollars for delivery in a month at a fixed exchange rate while simultaneously buying 1,000 pounds forward for delivery in two months, at a different exchange rate. As a result, the dealer can borrow pounds at a fixed rate without the risk of an unfavorable movement in the value of the currency.
In addition to hedging against foreign exchange risk, some investors use swaps to speculate on the movement of foreign currency. Speculators will take bets on the future value of a currency and invest in either a long or short position to take advantage of the volatility. If investors feel that the value of a currency will depreciate in value, they can use swaps to take a short position on that currency to try to earn a return.
Foreign exchange swaps provide customized solutions for the borrowing parties. As a result, swaps are privately exchanged and are not customized for trading. There is no exchange that a swap can be bought and sold on. Instead, investors and financial institutions work with banks to agree on a foreign exchange swap.
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