How Foreign Exchange Swaps Work - dummies

How Foreign Exchange Swaps Work

By Ayse Evrensel

The name swap suggests an exchange of similar items. Foreign exchange swaps then should imply the exchange of currencies, which is exactly what they are. In a foreign exchange swap, one party (A) borrows X amount of a currency, say dollars, from the other party (B) at the spot rate and simultaneously lends to B another currency at the same amount X, say euros.

In this case, each party has a repayment obligation to the other: A has to payback dollars; B has to payback euros. At maturity, A makes payments to B for X dollars at the forward rate as determined at the start of the contract. And B pays A his X amount of euros.

Therefore, foreign exchange swap works like collateralized borrowing or lending to avoid exchange rate risk. 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.

The daily turnover in global foreign exchange markets was close to a whopping $4 trillion in 2010. About 38 percent of this daily activity was due to spot transactions, which means exchanging currencies for immediate delivery. The remaining 62 percent involved foreign exchange derivatives. And among foreign exchange derivatives, the lion’s share went to foreign exchange swaps with 45 percent. When a financial instrument is that important, you want to know about it.

You can check out a very interesting report (Report on Global Foreign Exchange Market Activity in 2010) prepared by the Bank for International Settlements (BIS, located in Basel, Switzerland) on global foreign exchange activities both in spot and derivative markets.