Forex Basics – Of Swaps, Forwards and Futures

Details Published on Wednesday, 17 October 2012 21:38

The number of people actively trading foreign exchange has multiplied tenfold over the past decade.

Driven by a growing field of retail aggregators, this challenging market continues to attract investors searching for positive returns.  While access to Forex trading has been democratized through online platforms and low starting capital requirements, knowledge of the basics of the market has dropped significantly. This article will try to counter this trend with an in-debt look at swaps, forwards and futures.

Spot and the Value Date

We will start with the notion of the ‘value date.’  Value dates are of essential importance, but in an effort to simplify terminology, most retail brokers completely ban them from their systems. As a result, the bulk of users today simply ignore them. The value date is also known as settlement, maturity or delivery date.

Now, let’s take a step back and get even more basic.  Any Forex transaction can be described as a contract, where two parties agree to an exchange of one currency against another.  If I go to the money changer to exchange my local currency against a foreign currency in order to have some spending cash for my holiday, I will only receive those foreign bills after having handed over my money.  In other words – there is an immediate cash settlement – the value date of this transaction is today.  When it comes to trading foreign exchange, deals that are not settled in liquid cash, instead both parties involved must somehow agree to a date when the respective amounts of currency will be paid and received, this will be the value date.

In the interbank market, the most commonly used value date is called ‘spot.’  Since immediate cash delivery is not practical and to reduce the risk of false payments, banks worldwide have agreed to defer settlement of transactions done today by one or two business days.  This allows for a proper confirmation processes between the two counterparties, before payment risks occur.

Because foreign exchange spans currencies around the globe and in order to have sufficient time for trade-reconciliation, most countries have chosen to defer currency settlement by two days.  Exceptions to this rule are exchanges between North American currencies (USD, CAD and MXN) as well as the Turkish Lira (TRY), which are generally handled with a 1-day delivery.

Avoiding Settlement

While some counterparties, such as manufacturers or importers, have an underlying need to make settlement payments of their foreign exchange transactions, many are looking to avoid them. This is especially true for clients that hold Forex exposures for investment purposes only, targeting benefits through movements of the exchange rates. For these counterparties and their banks or brokers, full settlement would do nothing but increase the risk of payment default. With the use of a simple financial instrument called a ‘Swap,’ settlement and their risks can be avoided.

The definition of a currency ‘Swap’ is the simultaneous BUY and SELL (or SELL and BUY) of the same amount of the same currency pair but for two different value dates. These two simultaneous transactions are called ‘legs.’ In practice, the near leg will offset the existing position on its settlement value and re-open the original exposure with the far leg for a new value date. The exchange rates of the two transactions are linked to the current market price and the interest rate levels of the two currencies involved.

Once again, let’s take a step back and think in very basic terms in order to grasp the concept of the swaps pricing.  In any spot Forex transaction, both of the counterparties will receive one currency against which they need to deliver the counter value of the other currency on settlement day. The counterparties will agree to defer the settlement of this transaction to a date that lies further in the future using a swap.

What this really means is that counterparty A gets to keep currency X in his possession longer for which he will receive the X-interest. At the same time, he will not yet take possession of currency Y, giving up the opportunity to earn the Y-interest. In the case that X-interest is larger than Y-interest, deferring the payment is a ‘good deal’ for which counterparty ‘B’ will be asking compensation. In the opposite case, where the X-interest is smaller than the Y-interest, ‘A’ will only be happy to agree to the swap, if he receives compensation. This compensation is expressed as price difference of the two exchange rates of the swap.

The Swap Price

Summing up – a swap is a tool that allows shifting the value date of a foreign exchange exposure.  This is done through two opposing transactions with different value dates. The compensation received/paid is built into the price difference of the exchange rates of the two transactions. Now, we will establish how this is calculated.

This is an excerpt from November 2009 issue of Forex Journal.