Swaps are used primarily by investors and borrowers, and for cash management purposes. They are valuable to those who have liquidity in one currency but need liquidity in another currency. Typically, a client will buy spot and sell forward to generate liquidity in the currency purchased at spot. That is, if a client exchanges dollars for francs at spot and simultaneously exchanges francs forward for dollars, the client has created liquidity in francs (i.e. has them to spend) until the forward date. A foreign exchange swap is an alternative to straight borrowing in a foreign currency.
A swap allows the two parties involved to use a currency for a period in exchange for another currency not needed at that time. For example, companies can access foreign currency to finance foreign currency denominated assets, such as those of a foreign subsidiary. Hence, foreign exchange swaps can help clients to diversify their investments, to fund intracompany loans, to fund a position rather than use the money markets, to potentially improve the yield with no exchange risk in conjunction with a foreign currency investment, and to minimize borrowing costs in certain cases by using a swap rather than straight borrowing in a foreign currency.
In such a contract, the exposure is therefore one of interest rate risk rather than currency risk. Consequently, market makers will only charge, or pay, the interest differential. In the swap market, this interest differential is expressed, again, in points or pips.
The formula for determining the interest rate differential underlying the swap pips is:
where C = currency interest rate
T = period in number of days S = swap pips as a decimal added or deducted B = outright forward rate.
Swap pips are unequal, which can be seen in Figure 12.1.
As can be seen, the client has to borrow dollars at the higher rate, but can only invest yen at the lower rate. Similarly, the client has to borrow yen at a rate lower than the deposit rate in dollars.
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