FX Swap: The Swiss Army Knife of Financiers!

Introduction

The FX swap is the most widely used foreign exchange instrument among all those that exist. As shown in the graph below, they represented over 50% of the total volume of foreign exchange instruments in 2022. This article does not aim to describe the evolution of FX swap volumes by different counterparties, nor does it intend to explain the average maturity of an FX swap over a given period. Numerous online articles cover those topics. Here, we will focus on the practical use that treasurers can make of FX swaps.

Definition

An FX swap is simply an exchange of currency at a given time (T) followed by a second exchange in the opposite direction at a later time (T2). That’s it!

For example:

You enter an FX swap with your bank, where you exchange dollars for euros on September 17, 2024, and agree to swap back to dollars in one month at a pre-agreed rate. The transaction has two parts:

1. On September 17, you pay the bank USD 1,000,000 at 1.1090 You receive EUR 901,713.25 from the bank Place this amount for one month at 3% and receive EUR 2,254.28 in interest
2. On October 17, the bank pays you USD 1,000,000 at 1.1103 You pay the bank EUR 900,657.48

That’s all! Easy, right?

You earn EUR 3,310.05 on this transaction.

This profit simply arises from the interest rate differential between the dollar and the euro over a one-month period and from the placement of euros.

Alternatively, you could have:

1. Placed your million dollars for one month at 4.5%
2. Converted the USD interest to EUR in a month at the forward rate of 1.1103

You would have earned: EUR 3,377.46

Note the slight difference between the income from the swap and from a straightforward deposit. In a perfect market, there would be no arbitrage between these two markets; however, certain factors can temporarily create distortions.

For example, a speculative buying spike on the EUR/USD due to unexpected economic news may cause demand for EUR in the forward market to shift swap points upwards, widening the interest differential without immediately affecting the deposit market. If the gap between the two markets persists or grows, arbitrageurs will exploit these anomalies by:

• Selling EUR/USD forwards in the market
• Borrowing EUR at a forward maturity
• Selling EUR/USD in the spot market
• Placing USD at a forward maturity

Other economic or political factors can also create distortions. For example, after the 2008 financial crisis, there was a shortage of dollars as banks stopped lending to each other. Banks worldwide needed dollars to refinance positions and meet dollar commitments. They had no choice but to turn to the FX swap market for dollar funding, causing the implied dollar interest rate to increase more than the deposit rate.

1. Protecting your investment in a foreign currency

Suppose you’re an entrepreneur based in Hong Kong looking to invest in France, such as purchasing a building. You plan to sell this property in 2 years.

The problem is that over the next 2 years, the EUR/HKD value will fluctuate, and if the rate is lower at the time of sale, you will incur a loss on your investment.

Example:

You have HKD 10M in your Hong Kong bank account, and you enter an FX swap to make your real estate investment and cover it for the duration of your investment:

Property value: EUR 1,300,000

Today, you enter an FX swap with your bank, and they offer you the following swap contract:

On September 24, 2024: Buy EUR 1,100,000 at a rate of 8.67, selling HKD 9,537,000

On September 24, 2024: Sell EUR 1,100,000 at a rate of 8.775, buying HKD 9,652,000

In addition to protecting yourself, you benefit from a favourable interest differential—why not take advantage?

However, in cases of unfavourable interest differentials, such as for a Japanese investor investing in the U.S., the question of hedging becomes more nuanced. Does the yield gap between American and Japanese assets justify a currency risk? For institutional investors, hedging is non-negotiable.

Only, when interest rates are low and the yield curve is normal (not inverted), it’s possible to generate yield if the monetary policies of the countries you’re exposed to remain stable.

Example:

In April 2022, you invest in a 10-year U.S. Treasury bond with a yield of 1.7%, while a Japanese government bond with the same maturity yields 0.08%. The million-dollar question: Is the cost of hedging higher than the interest differential over the period?

As an investor, I could check the historical monthly USD/JPY swap price over the first 12 months and see how much hedging would have cost.

Hedging over the year would have cost US$ 60,602.53, or 0.66% of my investment, while the 10-year U.S. Treasury yield returns 1.7%.

But nothing guarantees that short-term rates won’t shift against me over the next 19 years... This is exactly what happened. In March 2022, the Fed began raising rates while the BOJ held steady. Result? The hedging cost exploded over the following year (May 2022 to April 2023), reaching 3.4%, surpassing the 1.7% yield on the 10-year U.S. bond.

2. Borrowing in another currency with cash as collateral

Your HK-based company wants to make an acquisition in France worth 1 million euros. You have two options:

a. Take out a EUR loan from a French or Hong Kong bank, then cover it with forwards to match the investment’s maturity.

This method can be lengthy and tedious, as the bank will need to examine your assets and require collateral, after which you may need to arrange separate forwards for FX coverage.

b. Alternatively, do an FX swap with your bank! Simply exchange your HKD for EUR and agree to buy back at a later date.

3. Manage your working capital

For businesses, effective cash management is key, and inefficient management can lead to unwanted losses.

Consider a Hong Kong-based company in the FnB industry. Here’s a snapshot of part of its balance sheet as of October 15.

The company’s treasurer has several options for optimizing working capital management.

Initially, they could cover their FX risk on October 15 by :

• buying EUR 200,000 vs HKD with value dates of November 15
• buying EUR 200,000 vs HKD with value dates of December 15
• Buying HKD 110,000 vs EUR spot or forward against EUR for the shortfall in payroll.

Yes, but this isn’t the most efficient way to cover the company’s exposure.

The treasurer can use EUR/HKD swaps starting October 15:

Here’s the breakdown of two swap transactions:

• Sell/buy EUR 200,000 against HKD First leg: October 20 Second leg: November 15
• Sell/buy EUR 200,000 against HKD First leg: November 5 Second leg: December 15

With these two swap operations, the treasurer optimizes the company’s cash flow imbalances. Managing cash with swaps instead of spot/forward purchases reduces FX coverage costs.

4. Arbitraging cash placements

Another major benefit of FX swaps is using them to efficiently place excess cash, optimizing returns and managing associated FX risks. Let’s see how this works with an example.

Assume your treasury is composed of 20% U.S. dollars and 80% Chinese yuan. You can either place this cash in a term deposit with your bank or use FX swaps. The swap market, being more dynamic than the deposit market, offers frequent opportunities when market events make swaps preferable to term deposits.

In recent years, there have been numerous times when using FX swaps was more advantageous than deposits. For the yuan, this is often due to the PBoC taking steps to prevent massive depreciation against speculators, which shifts swap points to the right. Deposit rates are rarely as responsive.

A recent example is the surge in Hibor (Hong Kong interest rates) due to a stock market rally. In September, Chinese economic support measures drained liquidity when the monetary base was already low.

Consequently, while the 1-month Hibor increased, deposit rates, being less elastic than swap rates, might not have allowed businesses to benefit from this rate increase, which is still ongoing.

5. Managing FX forward exposure

The final important point to elaborate on is the management of your forward contract exposure. When you hedge for your company, you have a specific coverage maturity in mind, but does it exactly match the date when you’ll need to settle the contract? Probably not. If you cover for a 4-month period, for example, and the contract settlement date falls on March 28, 2025, it’s very likely that your client will not pay you on this exact date, meaning your hedge will not be perfect.

Let’s look at a concrete example:

On November 18, 2024, you sell 3 million euros against U.S. dollars with a settlement date of 5 months (April 22, 2025) at a rate of 1.0602.

Your client notifies you that they wish to make an early payment on March 4 for an amount of 1 million euros, covering a portion of the contract. You agree, wanting to maintain a good relationship with them, but you don’t have the cash available to settle the amount due in dollars.

You can perform an FX swap to settle part of the contract in advance.

Before your client’s request:

On April 22:

• You owe the bank: EUR 3M
• The bank owes you: USD 3,180,600

On February 25, your client informs you of their intention to make an early payment on March 4:

You enter into a currency swap with your bank on February 28:

1. You sell 1 million euros to the bank at a rate of 1.0830 (the EUR rate appreciated in the meantime); the bank sells you 1,083,000 dollars on March 4.
2. You buy back 1 million euros from the bank at a rate of 1.0850; the bank buys 1,085,000 dollars from you.

This way, on the 4th, you can pay your client 1,060,200 dollars.

After your client’s request:

On April 22:

• You owe the bank: EUR 2M
• The bank owes you: USD 3,180,600 + 1,083,000 - 1,060,200 - 1,085,000 = USD 2,118,400

You’ll notice that the average exchange rate after the swap operation is slightly worse (1.0592) than your initial hedging rate (1.0602). This is entirely normal. Since the swap points on EUR/USD are positive, it’s normal that you have to finance the swap. If you were a euro buyer, the opposite would have been true, and your final hedging rate would have been improved.

Conclusion

In conclusion, FX swaps are a versatile and essential financial tool, not only for hedging FX risk but also for optimizing cash management, facilitating international acquisitions, and capitalizing on arbitrage opportunities. Whether it’s for hedging foreign investments, managing working capital, or proactively handling currency exposure, FX swaps empower companies to navigate a complex financial environment effectively. By employing these strategies, businesses can not only minimize risks but also potentially enhance financial returns based on market conditions.