A swap transaction is a foreign exchange or forex spot (current market rate) purchase or sale transaction together with simultaneous forex forward (future market rate) purchase or sale transaction. In the forex market, swap transaction is sometimes referred to as a "sell and buy," or a "buy and sell." One of the main features of a swap transaction is that there is no currency exposure; the spot transaction exactly matches the opposite forward transaction.
Quoting a Swap
Swap points are the added or subtracted pips from the spot rate. pip image by Henryk Olszewski from Fotolia.com A swap rate is quoted exactly the same as a forex forward rate (130-135). It is quoted as the number of points (pips) to be added or subtracted from the spot rate. If the forward points ascend from left to right, they are added to the spot rate. For example, the GBP/USD spot rate is 1.4450-1.4452 and the forward points are 130-135; they are added to the spot rate and the forward outright rate is 1.4582-1.4587. If the forward points descend from left to right (135-130) they are subtracted from the spot rate, and the forward outright rate is 1.4315-1.4322.
Premiums
The swap points represent the difference in the interest rate level between two currencies. If the GBP/USD spot rate is, for example, 1.4400-1.4402 and the "one month forward points" are 130-135, the points are added to the spot, and the forward rate is 1.4582-1.4587, putting the base currency (the sterling pound) at a premium forward. In other words the sterling is more expensive 1 month forward than the spot rate. The percentage difference between the spot rate and the forward rate is the same percentage difference between the sterling and the dollar's one-month interest rate. With the currency which is at a premium having a lower interest rate than the other currency.
Discounts
If the swap points are quoted as 135-130, they are subtracted from the spot rate 1.4400-1.4402, making the forward rate 1.4315-1.4322. This time the base currency sterling is at a discount to the spot in the one month forward. Sterling is cheaper than it was at spot. This reflects that the sterling's one-month interest rate is higher than the dollar's one-month interest rate.
Periods
Swap rates are usually quoted for periods of one, two, three, six, nine and 12 months. They can also be quoted for two and five years.
Uses and Users
A swap is a perfect hedge against currency risk. seat and garden decoration in front of yew hedge image by L. Shat from Fotolia.com Forex or currency swaps are used to hedge against exchange or currency risk. The people who use currency swaps are treasurers of large corporations who want to: speculate on a change in interest rate differentials; use a swap as a way to borrow money for a short period of time; extend or rollover an existing forward contract; or take a view on future interest rate differentials.
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