Forex trading involves several different mechanisms and concepts. Every trader needs to understand these terms. In this article, we will explain the concept of swap in Forex trading.
Foreign currency swap
A foreign currency swap is also known as an FX swap. It is an agreement between two parties to exchange currency. The foreign currency swap agreement comprises swapping controls and interest payments based on a loan made in one currency and its equivalent principal and interest payments of a loan of the same value in the second currency. One party involved in the foreign currency borrows one currency from the involved party and lends them another currency.
Here is an explanation of the Foreign currency swap. For a Foreign currency swap to work, two parties are necessary. These parties hold one currency, and the other party should be interested in it. There are two “legs” involved in the forex swap.
Leg 1 on the initial date
The first leg in the Forex swap is the transaction made at the prevailing spot rate. Both parties swap their currencies in the same amount and values at the respective spot rate. Hence, the spot rate is the exchange rate at the initial date.
Leg 2 on maturity
The second leg refers to the second transaction made at maturity. At maturity, both parties swap amounts again. This allows them to receive the currency they loaned at the initial date and return the currency they borrowed to the other party.
The forward rate is also involved in the Forex swap exchange. It is the exchange rate on the full transaction between two parties. A forward rate is determined by estimating the relative appreciation or depreciation of the involving currencies.
Expectations arise from the interest rates offered by two currencies, as shown in the parity of interest rates. Suppose currency A offers higher interest rates; it compensates for expected depreciation against currency B in the swap.
Forex currency swaps are very beneficial for administering and aiding in cross-border loans. It makes it easier for both parties involved in the swap/loan to calculate and make up for the disparities. Forex swap also aids by diminishing the future exchange risk by introducing a forward rate and making the future payment known to both parties.
A practical example of a Forex swap
Let us suppose that two parties are interested in the Forex swap.
- Party A is Canadian and needs euros.
- Party B is European and needs Canadian Dollars.
- Both parties proceed towards a Forex exchange swap.
- They decide the maturity period is six months.
- They agree on the swap rate of 1.5 EUR/CAD.
- Hence, they exchange 100,000 Euro or 150,000 CAD.
- Since they expect depreciation of CAD, they decide on the forward rate of 1.6 Euro.
The initial exchange party gets 100,000 Euros and gives 150,000 CAD to party B. After six months, party After six months, party A returns the 100,000 Euros to part B and receives 160,00 CAD based on a 1.6 forward rate from party B. This transaction ends the Forex swap.
Forex swaps are a good way to manage transactions between two parties based on two different currencies. It allows the transactions to be fair. If you want to know what time does the forex market open, make sure to follow this article on our website.