The German company is quoted an outright price of 1.3791026 by their bank.
Is this outright price correct? The company is selling EUR and buying USD and is, therefore, dealing on the bid side of the spot market at 1.3791 which is correct. However, instead of using the bid tom/next swap points (–0.033), the offer tom/next swap points (–0.026) have been used. Although the tom/next swap points are shown as negative, they have been added to the spot rate. The transaction looks like this because we have come back in time.
With all outrights the first thing the bank trader must do is to lock in the spot rate and this is done here by selling the EUR for USD spot at 1.3791.
The bank now has the following two trades to settle:
- A purchase of EUR for USD value tomorrow with the German company
- A sale of EUR for USD value spot with an interbank counterparty
While the net exposure for the bank is effectively zero, there remains a settlement mismatch. One transaction settles tomorrow and the other settles on spot. Therefore, the bank then joins these two transactions by entering a tom/next swap.
Under this tom/next swap, it:
- Sells EUR to its swap counterparty on the near leg (tomorrow) at 1.3791026 (1.3791 + (0.0260 × 0.0001))
- Buys EUR back from its swap counterparty on the far leg (spot) at 1.3791
It is swapping EUR with a high interest rate for USD with a low interest rate. As a consequence, it would expect to be paid the interest differential which in this case is 0.00000260, the offer side of the swap market. This is added to the spot rate to achieve the tom/next outright rate.
To summarize, the bank:
- Buys EUR from the company value tomorrow at 1.3791026. This is the rate which the company is quoted.
- Sells the EUR on the front leg of the swap value tomorrow at the same rate.
- Buys back the EUR at 1.3791 at spot reflecting a price of 0.0000026 points on the swap trade.
- Sells the EUR received on the far leg of the swap in the spot market at 1.3791.