Protect yourself from exchange rate risk with a foreign exchange swap.
A foreign exchange swap is a contract between two parties that involves simultaneous borrowing and lending. The underlying mechanics can take a little time to understand, but the benefit of a swap is simple: You protect yourself from fluctuating exchange rates.
What is a foreign exchange swap?
When you enter into a foreign exchange swap — also called as a forex swap or FX swap — you:
- Borrow a currency from another party, and
- Lend a second currency to that party at the same time.
An FX swap essentially comprises two contracts: a spot transaction that’s executed immediately and a forward transaction that’s executed at a specific date in the future.
For example, at the start of a swap contract, you might borrow euros from a business owner in France while lending him dollars. When the contract expires, you’ll return the euros to the business owner, and he’ll return the dollars to you.
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Why is a foreign exchange swap useful?
When making any large transaction with foreign currency, you’re worried about losing value in your investment due to unfavorable movements in exchange rates. This is known as foreign exchange risk.
An FX swap comes with two big advantages:
- Because the other party sends you currency, you hold collateral for the money you lent. The other party also holds collateral because you sent money to them.
- From the very beginning, you know exactly how much you need to pay back to the other party at the end of the swap agreement.
For these reasons, an FX swap could allow you to eliminate foreign exchange risk.
Who uses foreign exchange swaps?
Many parties use FX swaps, from financial institutions to institutional investors to multinational companies. They often use these swaps to protect their investments in foreign currencies. FX swaps are also commonly used by speculators.
What is a forex speculator?
A speculator is a person who trades currencies, commodities and other forex assets with a higher risk of losing their money in return for a higher-than-average possibility of substantial gains on their investment.
Foreign exchange swaps: An example
Let’s say you’ve just sold merchandise worth 50,000 euros. You’ll need to pay your suppliers in France, but not right now — you can pay them in five months.
You operate in the United States, and you need dollars now. So you initiate an FX swap. You borrow dollars from a business owner in France and send her euros at the same time. Per your swap agreement, you’ll repurchase euros in five months at a set rate.
Are there any drawbacks?
FX swaps do include a few drawbacks:
- There’s a chance one party might default on a swap contract.
- Because exchange rates are agreed on beforehand, you could lose out on potential profit if the exchange rate were to move in your favor.
What does it mean to “default” on a contract?
When a contract is at risk of default, it means that there is a possibility that one of the parties may not be able to fulfill its obligation specified in the contract.
Is there anything else I should know?
Foreign exchange swaps are different from currency swaps, which involve exchanging principal and interest payments from separate loans. Learn more about currency swaps.