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foreign exchange Swaps

Page history last edited by Brian D Butler 11 years, 9 months ago

 

Swaps

 

a swap is a spot sale of a currency, combined with a forward repurchase. You combine these two activities into one, so that the transaction cost is reduced. Instead of paying for two separate transactions, you just pay for one. As a result of the cost savings (lowered broker fees), foreign exchange swaps now make up a large portion of all FX trading.

 

example of a FX swap: a company received money from customers in the US, and has to pay suppliers in the US in 3 months. They may decide to invest short term in EuroBonds. A three month swap of dollars into Euros is a cost effective way to do so. Otherwise, the company would need two separate transactions - (a) sell dollars for spot Euros, and then also (b) sell those Euros for dollars on the forward market. By instead doing the "swap", the company is able to reduce the steps to just one.

 

Other types of Swaps:

 

see GloboTrends page on swaps

 

 

Swap lines with foreign Central Banks

 

currency swaps are the provision of dollars to foreign central banks to help satisfy dollar-based liquidity needs in foreign financial markets

 

The best description of what a "swap line" is and how it helps bring about global liquidity comes from "Atlanta Fed's macroblog"  Link here:  http://macroblog.typepad.com/macroblog/2008/09/thursdays-post.html

 

"A currency swap is a transaction where two parties exchange an agreed amount of two currencies while at the same time agreeing to unwind the currency exchange at a future date.

 

Consider this example. Today the Fed initiated a $40 billion swap line with the Bank of England (BOE), meaning that the BOE will receive $40 billion U.S. dollars and the Fed will receive an implied £22 billion (using yesterday’s USD/GBP exchange rate of 1.8173).

 

Currency Swap:

Figure 1

 

An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in England need funding in U.S. dollars as well as in pounds.

 

However, banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term U.S. dollar funding and has been evident in a sharp escalation in LIBOR rates.

 

The currency swap lines were designed to inject liquidity, which can help bring rates down. To take the British pound swap line example a step further, the BOE this morning planned to auction off $40 billion in overnight funds (cash banks can use on a very short-term basis) to private banks in England.

 

Figure 2

 

In effect, this morning’s BOE dollar auction will increase the supply of U.S. dollars in England, which would work to put downward pressure on rates banks charge each other.

 

 

Consistent with this move, the overnight LIBOR rate fell from about 5.03 percent yesterday to 3.84 percent today.

Figure 3

 

 

The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that banks and other businesses need to operate.

 

By Mike Hammill in the Atlanta Fed’s research department

 

Read more here:  http://macroblog.typepad.com/macroblog/2008/09/thursdays-post.html

 

 

 

More links

foreign currency trading

spot exchange rate

forward exchange rate

Currency

appreciation

depreciation

 

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