The popularity of FX swaps and FX forward contracts exploded over the past two decades, accounting for nearly 50% of the $7+ trillion daily turnover in today’s Forex market. It also represents a hidden threat to the global financial system, as companies do not have to record those transactions on their balance sheets.
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What Are FX Swaps? How Do FX Swaps Work?
An FX swap consists of two transactions between two parties. They are the preferred method of multinational companies to access capital outside their home market.
An Example of an FX Swap
- Company ABC requires $1,100,000 for a business expansion in the US, and in four months, it needs €1,000,000 for a distributor payment in the EU.
- Company 123 requires €1,000,000 for a business expansion in the EU, and in four months, it needs $1,100,000 for payment of a tax bill.
- Their financial institutions match the requirements, and the companies exchange capital via an FX swap at the FX spot rate on the date they enter the FX swap.
- At the same time, they enter into an FX forward contract dated four months from now to swap the funds at the same FX spot rate.
What Are FX Forwards? How Do FX Forwards Work?
An FX forward contract is a single transaction that allows companies to hedge currency risk. It is often used by commodity companies.
An Example of an FX Forward
- Commodity producer XYZ believes the Euro will decrease in value and wants to lock in the price for future delivery seven months from now when it delivers €5,000,000 worth of commodities to customer 123.
- It uses an FX forward contract worth €5,000,000 dated seven months from now at today's FX spot price, guaranteeing a more favourable price at delivery.
How FX Swaps and FX Forwards Differ
Understanding the difference between FX swap and FX forward is necessary before agreeing on either contract.
Four core FX swap vs. FX forward differences:
FX swaps | FX forward | |
|---|---|---|
Number of transactions | Two transactions, usually one FX spot transaction and one FX forward transaction, are agreed upon simultaneously by both parties. | One transaction at a future date at the best available FX spot price when the contract starts. |
Mechanism | Two parties agree to swap currencies when they enter the FX swap and decide to purchase the original currency at a future date. | One party agrees to purchase one currency for another at a future date at today’s FX spot price. |
When is it suitable? | An FX swap is suitable for a party requiring the base currency at a future date. | An FX forward is ideal for a party seeking to hedge its currency exposure. |
Period | It can last several years, depending on the agreement between both parties. | It can last several years, depending on the requirements of the party writing the contract. |
Deposit on FX Swaps
Let’s take a closer look at FX swap vs. FX forward requirements. Capital is necessary to enter an FX swap. Since an FX swap includes an FX forward as part of the second transaction, the parties must deposit a fraction of the total transaction size. Forex transactions usually involve leverage, and many FX swap deposits must only cover 10%. The amount may differ depending on the agreement between the parties and the banks or financial institutions involved in the transaction.
Different Types of Currency Swaps
As part of our FX swap vs. FX forward comparison, traders should be aware of the two primary types of currency swaps.
- Fixed-for-fixed rate currency swap: Two parties exchange fixed interest payments in currency A for fixed interest payments in currency B. In this currency swap, the two parties exchange the principal amount of the underlying loans.
- Fixed-for-floating rate currency swap: Two parties exchange fixed interest payments in currency A for floating interest payments in currency B. They do not exchange the principal amount of the underlying loans in this currency swap.
Pros & Cons of both FX Swaps & FX Forwards
Traders should consider the pros and cons before agreeing to the FX swap vs. FX forward offers.
The Pros of FX Swap Vs. FX Forward Contracts
- Protection against negative Forex fluctuations.
- A reverse transaction can close out the original transaction.
- Increased security as an FX swap guaranteed the return of principal at a future date.
- Companies do not have to record swaps and forwards on their balance sheets, improving their financial stability on paper.
- Access to cheaper loans.
The Cons of FX Swap Vs. FX Forward Contracts
- A fixed future exchange rate could be less favourable than the FX spot rate.
- Wrong assessment about the timing of capital requirements.
- Increased risk for longer-term contracts.
- Low liquidity.
- Higher costs to maintain contracts.
Bottom Line
Regarding FX swaps vs. FX forwards, the popularity of both derivative contracts and their hidden risks should be explored. An FX swap grants companies access to cheaper interest rates, while an FX forward allows a company to hedge against currency fluctuations. The former consists of two simultaneous transactions versus one for the latter.
