Forex swap, also known as a currency swap, entails the simultaneous purchase of two different currencies, one at the spot rate and the other via forward contract.

Foreign exchange swaps are used by a range of participants from the market which includes financial institutions, their clients, speculators, and institutional investors who want to hedge their forex positions. The main purpose of forex swaps is to protect the traders against currency risk.

How does swap work?

A forex swap is a contract of two parties exchanging a specific quantity of one currency to another based on the current spot rate. The initial funds traded will then be returned by two parties in a future time at a predetermined forward rate. This rate offsets any potential changes in the different currencies’ interest rates while fixing the forex rate wherein the money will be transferred on a future date.

As a result, this provides protection against future changes in forex rates for both parties. This is mainly the reason why exporting and multinational businesses find forex swaps to be very helpful.

Example of forex swap

To finance its operations in Japan, a Japanese company that sells goods in the US could desire to convert US dollars to yen, but a month from now it may need US dollars to pay its suppliers from America.

The dollar may rise against the yen if it is converted to yen today and then changed back to dollars at a later date.

In this case, the company might end up paying more yen for the same amount of dollars.

The corporation does a FX swap to prevent such losses. It exchanges dollars to yen at a spot rate and contracts for a month forward in the same amount of yen at the same time. This enables it to acquire the dollars needed without experiencing currency swings to cover the US payment that they need in a month’s time.

FX swap can also be carried out by two firms.

A forex swap can be arranged between a Japanese corporation in need of dollars and a US company that needs yen. Both companies can agree on the amount, date and interest for the transaction.