Forex SWAPs

Forex SWAPs are a tool for hedging foreign exchange risk.

Characteristics

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a "fixed rate/fixed rate" swap.

The main objectives of a forex swap are:

• To hedge against forex risk, possibly for a longer period than is possible on the forward market.
• Access to capital markets, in which it may be impossible to borrow directly.

Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.

Illustration

Suppose that A plc, a UK construction company, wins a contract to construct a bridge in Argentina. The bridge will require an initial investment now, and will be sold to the Argentinean Government in one year's time. The Government will pay in pesos.

The problem is the company's exposure to currency risk. They know how much will be received in one year's time in pesos but not in sterling as the exchange rate changes daily.

Various possible hedging strategies:

(1) Decide to do nothing, i.e. accept the risk - win some, lose some.

(2) Lock into a forward contract for converting the amount receivable in one year's time into sterling, if a forward market exists.

(3) Undertake a money market hedge: take out a loan in pesos to cover the initial cost, and repay the loan from the disposal proceeds in a year's time. We would then only be exposed on the profit we make (if we make any).

(4) Enter into a forex swap. Instead of taking out a loan in pesos we

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