This swap has used a mid-market spot rate of 1.6823 to anchor it and define the spot cash flow. This rate is determined between the bank and the company at the time of agreeing the swap price and the rate used must be close to current spot (1.6822/24). The difference between the spot and forward prices used must be the swap points traded. If 1.6823 is used as the spot rate, the forward rate is 1.681866. If 1.6824 is used as the spot rate, the forward rate is 1.681966.
Note that if the cash flows were reversed and the company had use of the higher yielding GBP for a month it would have to pay 4.44 swap points. The difference between the sets of swap points pip is the swap trader’s dealing spread.
The shortcut to assess which side of the swap to use is to look at what the company is doing on the forward leg of the swap; it is buying GBP. This would put it on the offer side of the market if it was trading spot. The same logic can be applied to the swap points.
Trading Language: When transacting swaps, traders and clients indicate which trade direction they require by describing what they are doing on the spot and forward legs. In the example above the company was "selling and buying" GBP at 4.34 (selling GBP at spot for USD and buying GBP forward against USD).
Other Uses of FX Swaps
Here we will look at other uses of FX swaps:
Moving Maturity Dates
Companies using forward outrights are often not sure of the exact date that a particular payable or receivable will happen. A company might transact a forward outright for its best "guesstimate" of the date. Then, when the cash flow date is confirmed, it might find that it is exposed for the period between its guestimate and the actual date.
To cover its exposure for this period, it might use an FX swap to move the maturity of the outright to the actual cash flow date.
Maintaining Open Positions
Traders and fund managers may take positions in the FX market as a means of speculating on the future direction of that currency. They may maintain the position in that currency for a period longer than that available under a spot trade.
By executing an FX swap (such as a spot/next swap), the trader is able to move the settlement of the open position from spot to the next day; essentially three days from today. When the trader returns to their trading desk the next morning, they have a spot position for settlement in two days.
Covering Short Positions
Financial institutions manage virtually all of their gross foreign currency positions on a daily basis. This involves swapping currencies from where they have a surplus to cover those where they are short. Financial institutions do this in order to avoid borrowing costs when covering their short positions.
Most of these transactions are done as a one-day swap in the overnight market creating massive turnover in the swap market.
Review Question
Which of the following statements is false?
- The difference between the spot and forward price is typically expressed as percentage of spot.
- An FX swap is the simultaneous buying of one currency for another at spot and selling back that currency for the original on a settlement date in the future.
- Swap points reflect the difference in in the level of interest rates in the two currencies.
Answer:
1) Correct. In fact, the difference between the spot and forward price is expressed in swap points. These points reflect the interest differential between the two currencies.