What is a Foreign Exchange Swap and How does it Work?

For instance, given the hundreds of billions of swaps of yen for dollars by Japanese banks, the Japanese authorities have encouraged their banks to extend the maturities of their swaps (Nakaso 2017). Schrimpf, A and V Sushko (2019a), “Sizing up global foreign exchange markets”, BIS Quarterly Review, December, pp. 21–38. US non-banks have sold only $600 billion in non-dollar-denominated debt to non-residents (US Treasury et al (2016)).

1. These questions, together with their regulatory implications, would merit further consideration.
2. Similarly, there is a visible, if weaker, co-movement between international bonds outstanding (yellow) and longer-term currency swaps (light blue).
3. Precisely because the instruments are off-balance sheet, a systematic analysis is not possible.
4. In a foreign currency swap, each party to the agreement pays interest on the the other’s loan principal amounts throughout the length of the agreement.

To be sure, such risk is mitigated by the other currency received at maturity. Most maturing dollar forwards are probably repaid by a new swap of the currency received for the needed dollars. This new swap rolls the forward over, borrowing dollars to repay dollars. The forward creates an obligation to come up with foreign currency (a liability), matched by the right to receive the domestic currency (an asset), both equal to the current value of the foreign currency asset.

Dollar Debt in FX Swaps and Forwards: Huge, Missing and Growing

Interest payments are exchanged at fixed dates through the life of the contract. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company’s balance sheet. These episodes point to a need for statistics that track the geography of outstanding short-term dollar payment obligations.

Once a foreign exchange transaction settles, the holder is left with a positive (or “long”) position in one currency and a negative (or “short”) position in another. In order to collect or pay any overnight interest due on these foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them for the following day. To do this they typically use “tom-next” swaps, buying (or selling) a foreign amount settling tomorrow, and then doing the opposite, selling (or buying) it back settling the day after. Foreign currency swaps can be arranged for loans with maturities as long as 10 years. Currency swaps differ from interest rate swaps in that they can also involve principal exchanges.

FX swaps, regulation, and financial stability

This matched global GDP in 2021 ($96 trillion) and was three times global trade ($29 trillion). And it exceeded both global external portfolio investment ($81 trillion) and international bank claims ($40 trillion) at end-2021. Foreign currency swaps can involve the exchange of fixed rate interest payments on currencies.

In the process, it also shows what would happen if FX swaps were treated the same as repurchase agreements (repos) – two transactions that can be considered to be forms of collateralised lending/borrowing. The table shows the corresponding balance sheets, with the subscript X https://g-markets.net/ denoting foreign currency positions. This off-balance sheet dollar debt poses particular policy challenges because standard debt statistics miss it. The lack of direct information makes it harder for policymakers to anticipate the scale and geography of dollar rollover needs.

What is a Debt Swap?

Another aspect worth highlighting is the principal for cross-currency basis swaps is returned at the same FX rate derived from the FX spot market at the start of the contract. As a basic example, let’s assume two companies, company A and company B, have each taken out a million-dollar loan on which they will make yearly interest payments to their respective lenders. Company A entered into a floating-rate loan based on the LIBOR and company B took on a fixed-rate loan of 4%. In all, the GFC and the COVID-19 pandemic point to a need for statistics that track the geography of outstanding short-term dollar payment obligations. The maturity of the instruments is largely short-term (Graph 1, centre and right-hand panel). At end-2016, three quarters of positions had a maturity of less than one year and only a few percentage points exceeded five years.

What are the limitations of currency swaps?

A FX swap, or Forex swap, is a foreign exchange derivative traded between two parties, usually financial institutions. Together, they lend and borrow an equal quantity of money in two different currencies over a specified time period. The fixed-floating interest swap, owing to its ubiquity, provides a solid foundation for understanding how a swap transaction functions, often referred to as a plain-vanilla swap.

Mary has a liberal arts degree from Goddard College and
spends her free time reading, cooking, and exploring the great outdoors. On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

In June 2014, the then largest US bond fund, PIMCO’s Total Return Fund, reported $101 billion in currency forwards, no less than 45% of its net assets (Kreicher and McCauley (2016)). Since the overall US holdings of foreign currency bonds were $600 billion at end-2015, a 50% hedge ratio would extrapolate to $300 billion. The parties involved in currency swaps are usually financial institutions, trading on their own or on behalf of a nonfinancial corporation. Currency swaps and FX forwards now account for a majority of the daily transactions in global currency markets, according to the Bank for International Settlements. 2 FX swaps and outright forwards cannot be distinguished in stocks data. Ideally, we would exclude from our analysis non-deliverable forwards (NDFs), which entail just a fractional payment, but they are not identified individually in the stocks data.

The mark-to-market loser regularly hands over cash or securities (“variation margin”) to the mark-to-market winner. Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the UK, LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021.

The outstanding amounts of FX swaps/forwards and currency swaps stood at $58 trillion at end-December 2016 (Graph 1, left-hand panel). Swaps can last for years, depending on the individual agreement, so the spot ascending triangle pattern market’s exchange rate between the two currencies in question can change dramatically during the life of the trade. They know exactly how much money they will receive and have to pay back in the future.

Moreover, as mentioned before, the resulting net positions are likely to underestimate the gross debt positions, especially for dealer banks. Most commonly, multinational companies or banks may be looking to hedge foreign exchange risk. If the currency declines in value, so does the interest payments on the loan (on a relative basis, keeping the ROI of an investment intact). Second, central banks lend dollars via FX swaps against either their own currency or third currencies. Against foreign currencies, some central banks lend dollars via swaps in the management of their FX reserve portfolio. For instance, the Reserve Bank of Australia swaps US dollars for yen (Debelle (2017)).