Collateral Management

CHAPTER 18OTC Derivatives and Collateral – Transaction Types – Foreign Exchange Swaps

This chapter describes the purpose of and characteristics of foreign exchange swaps, one type of OTC derivative product. Also described are a number of fundamentally important concepts of foreign exchange settlement, with their associated risks.

18.1 DEFINITION

A foreign exchange swap (FXS) is an OTC derivative contract in which two parties exchange principal amounts in different currencies at the start of the trade (at one exchange rate), with the reverse exchange occurring at the close of the trade (at a different exchange rate).

FXS are part of a family of financial products known as currency derivatives.

FXS are also known as ‘plain vanilla foreign exchange swaps’, ‘spot/forward fx swaps’, and ‘forex swaps’.

Note: in a foreign exchange swap, because the principal amounts are paid in full, the term ‘notional’ (meaning ‘theoretical’) is not applicable, consequently the terms ‘principal’ and ‘principal amount’ are used instead.

18.2 PURPOSE

FXS are used to mitigate foreign exchange risk.

Imagine that a firm needs to borrow a particular amount of a particular currency immediately, where the firm currently holds a different currency that the firm does not need immediately. An FXS trade is a temporary (therefore two-legged) exchange of the two currencies:

• in the first leg of the trade, the firm’s existing currency known as the base currency [ccy #1] is paid to the counterparty, versus ...