What is a Currency Swap in Forex Trading?

Currency swaps, or cross-currency swaps, are a kind of over-the-counter (OTC) derivative. It is a bilateral agreement between two traders in which both the principal and the interest payments on the currency are exchanged for a different one, held by the other side. The interest payments are exchanged at fixed intervals over the agreement’s span. These interest payments can have fixed interest rates, variable rates (also known as floating), or something in between according to the unique agreement the two sides agree on.

That was a mouthful, so let us break down what it means. Investopedia’s definition of a derivative is that it is a financial agreement between two or more parties about underlying assets, which they what the derivative’s value is derived from. With a currency swap in forex trading, it is the value of the currencies and their fluctuations at the set intervals. Derivatives benefit from usually being leveraged as you can have greater gains or greater losses from a smaller investment.

According to the Corporate Finance Institute, over-the-counter (OTC) trading between two different parties, is not in a formal exchange under its regulator’s supervision. Instead of using a formal exchange, this is done through dealers through dealer networks, decentralized and unphysical platforms. The benefit of OTC trading is that they are unbound by standardized items, allowing the currency to swap in forex trading, unlike formal exchanges. However, since these contracts are between two parties without a regulator, there is a credit risk of the other party not holding up their end of the agreement.

 Principal trading is buying a currency in any form and waiting for it to appreciate over time as stated on Wikipedia. The goal of the currency swap in forex trading is to have the principal i.e., the currency, increase in its value over time for the payouts at fixed intervals during the agreement’s lifetime.

 However, interest trading can be more important. The interest rate of the currency swap in forex trading is important twofold because it determines the interest rate that you receive for the currency that you have traded for, but also for the currency you have traded away. Currency swaps are not only loans as they function similarly, but they are two-sided loans of one currency against the other for a set amount of time as you give as well as receive different currencies, hence the name currency swap. The Consumer Finance website, an official US website, makes the difference between fixed interest rates as agreed upon by all parties beforehand and variable interest rates in which they stuck to an index. This can be the forex currency pair or anything else by the agreement. Furthermore, the different parties can agree on having different rates between them thanks to the nature of over-the-counter (OTC) trading.

The Uses of Currency Swap in Forex Trading

After a better understanding of what the specific derivative is, a question remains. What is currency swap in forex trading used for?

The Bank for International Settlements website state that currency swaps in forex trading, or as they call it forex swaps, do not appear on a company’s balance sheet or a trader’s portfolio. This can help institutions as well as individuals to receive an accounting leg up when it comes to paying taxes on their trading revenue.

 Beyond the principal trading that is done at the start and the end of the currency swap, the traders will also make interest-rate trades to one another at interval rates. Besides not mentioning it in their official balance sheets, this allows the companies themselves to set the terms of their loan themselves if the other party agrees to it. They can move one currency for the benefit of another. However, as an over-the-counter derivative, this is done only in cash and in the currency that they loan in. This may take some accounting expertise fit for investment firms and not for individuals. This can help them to buy cheap debt in the form of back-to-back loans. Nasdaq defines it as a burrowing country from an entity in another country. This is done to pay off a debt they may have in a different currency that they want to trade for. Therefore, they rely on installments from their other firm to pay off their previous debt in foreign currency.

 As investment firms and/or individuals sign an agreement of currency swap in forex trading, they usually trade back the same amount in the same currency after the time has elapsed. This is called the principal exchange. Because the value of the currency can change over time, this is often done to hedge rather than having gained from the opportunity cost. As defined by one of the largest banks in France, Societe Generale, hedging allows an investor to have fewer risks in their portfolio by holding multiple positions, in this case, multiple foreign currencies through a currency swap. This especially helps if a certain currency is forecasted to massively fluctuate for a certain period, and in turn, can affect a large portion of the company’s business in that currency. With the currency swap in the forex market, they can manage their risk better with hedging.

 Another way to even hedge better a currency swap in forex markets is to mark-to-market (MTM). According to the Economic Times, mark-to-market means that you trade back things at their current value. This means in a currency swap that you may have to give or receive compensation for the new value of the currency you traded with or traded for accordingly. However, some traders may see it as a good way to hedge their bets on relatively small amounts of money to be transferred on top of the regular return of currencies. This makes currency swaps perfect for companies to raise funds at relatively low risk.

 Currency swaps in forex trading can also act as a way to avoid an outright financial crisis localized to a specific country with its central bank. For example, the central bank can increase its interest rates to combat a recession, a giving sign to combat a financial crisis. Macro Hive has done a deep dive into forecasting financial crises that may come ahead. If you forecast one, having a currency that might be useless is not a good idea, and a currency swap can help offload some of that currency until its localized economy recovers.

Rollover Interest – Currency Swap in Forex Trading

As an induvial trader, you can also enjoy the benefits of a currency swap in forex trading. You do this with a rollover interest rate. According to Investopedia, it is a trade in which you trade one currency for another to forecast its worth that gain or lose by holding these positions overnight. The gain or loss is determined by the underlying interest rates of the involved currencies, and whether or not it’s a long trade or a short trade on the currency pair, forecasting that it will increase in value or decrease in value respectively. Currency swap interests will not apply for trades on the same day. You want to hold that position overnight as you buy a high-yielding currency against a low-yielding to maximize your revenue from the rollover interest, the currency swap in forex trading for individual day traders.

Conclusion

In conclusion, a currency swap in forex trading, also known as a cross-currency swap, is a valuable tool that allows traders, companies, and investors to exchange currencies and manage risk effectively. It involves the exchange of both principal and interest payments between parties, typically at fixed intervals, based on agreed-upon terms.

 Currency swaps offer flexibility and customization, as they are traded over-the-counter (OTC), without the involvement of a formal exchange. This allows parties to tailor the swap to their specific needs. However, it also introduces credit risk, as the agreement relies on the trustworthiness of the counterparty.

 The uses of currency swaps are diverse and include hedging against currency fluctuations, managing interest rate exposure, reducing tax liabilities, accessing cheaper debt in different currencies, and even avoiding financial crises in specific countries. Currency swaps provide opportunities for traders to earn revenue through rollover interest rates, taking advantage of interest rate differentials.

 By utilizing currency swaps, traders and businesses can navigate the complexities of the forex market more effectively and mitigate potential risks. These swaps play a crucial role in facilitating international trade, investment, and financial management.

 In summary, currency swaps are powerful instruments in forex trading that provide a means to exchange currencies, manage risk, and optimize financial strategies. Understanding the intricacies and benefits of currency swaps can significantly enhance one's ability to navigate the dynamic and ever-changing world of the foreign exchange market.