Foreign Exchange: A Practical Guide to the FX Markets

CHAPTER 8

Foreign Exchange Swaps or Cross-Currency Swaps or Cross-Currency Interest Rate Swaps or . . .

INTRODUCTION

There are several different types of swaps. There are interest rate swaps, equity swaps, volatility swaps, baseball card swaps, and, of course, foreign exchange swaps. As a matter of fact, there is more than one type of FX swap, and, as we have come to expect, several different names for these.

For the record, swaps are OTC contracts, so we are leaving the exchange-traded world of Chapter 7). Also, most swaps involve terminology and documentation that have been “standardized” by the International Swaps and Derivatives Association (ISDA) and require having a “master ISDA” in place prior to dealing.

FX SPOT-FORWARD SWAPS

For many who work in foreign exchange, an FX swap is interpreted as a spot-forward swap. What this means is that, unlike a “forward outright” (or standalone forward trade), the two counterparties agree to a forward trade (on a notional amount of one of the two currencies) and an offsetting (opposite) spot transaction (typically on the same notional amount of that currency). Since the forward trade changes the FX risk for the quoting bank, the associated (opposite and offsetting) spot trade reduces risk for the marketmaker to basis risk or carry risk (i.e., interest rate risk). In essence, this FX forward trade is turned into an interest rate trade, and often FX forwards and FX swaps are managed by the “cash” or interest rate desks at the banks ...