Outline
A kind of FX trade where Spot buying or selling of the spot is done simultaneously together with Forward buying or selling. It is a short term Swap of which maturity is less than 1 year.
Structure
- - As illustrated on the work-flow below, Company A can raise Won currency using USD Currency.
- - In operations, when the need for Won currency is temporarily made at the end of month or quarter, etc., the company holding US Dollars can easily raise the Won currency without FX risk needless of selling of the US Dollars they hold.
- Pricing for FX Swap
- - Swap price in FX Swap deal means the difference between the Spot rate and the Forward rate that are applied on Swap deal. In theory, it is determined as per the difference between the two currencies in pursuant to “Interest Rate Parity Theory”.
- Swap price calculation formula and example
- - In pursuant to Interest Rate Parity Theory, which provides that the capital can move freely between the countries and that there are no costs such as transaction charge,
tax, etc., the difference between the Spot rate and the Forward rate is decided based on the interest rate difference between the two countries
Forward rate > Spot rate: Base currency is at the state of Forward premium - - Base currency is the currency with interest rate lower than that of the counter currency, as such is compensational to the lower interest rate currency.
Forward rate < Spot rate: Base currency is at the state of Forward discounted - - Base currency is the currency with interest rate higher than that of the counter currency, as such is a burden to the higher interest rate currency.
- - Deriving the Formula
Deriving the Formula
Provided that an investor has 1 USD and that principal will be same regardless of the country to invest. Herein, assume he invests in US and Japan.
When to investing 1USD at the yield of Rf for d period in US, the principal is,
1USD X (1 + Rf X d/360) ----------------- 1)
After converting IUSD to Japanese Yen and investing it at the yield of rv, to change it at Forward rate, the principal is,
1USD X S(1 + rv X d/360)/F ------------- 2)
S : Spot rate of USD/JPY
F : Forward rate of USD/JPY
Formula 1) & 2) should be same, therefore,
1USD X (1 + Rf X d/360) = 1USD X S(1 + rv X d/360)/F
Accordingly, F = S X (1 + rv X d/360) / (1 + Rf X d/360) ---------------3)
Get Swap Rate (SR) by subtracting S from the both side of formula 3),
Swap Rate(SR) = F - S = S X {(rv - Rf) X d/360} / (1 + Rf X d/360) --------------- 4)
As a denominator (1 + Rf X d/360) of formula 4) is nearly close to 1, the formula can be simplified as below.
Swap Rate(SR) = F - S = S X {(rv - Rf) X d/360} ----------------- 5)
If Rf > rv in the formula 4), base currency is the higher interest rate currency. As such, the base currency becomes Forward discounted currency.
If Rf < rv, base currency is the lower interest rate currency. As such, the base currency becomes Forward premium currency.
Example
USD 3 months (90 days) Term Deposit Interest Rate : 3.5%
JPY 3 months (90 days) Term Deposit Interest Rate : 0.1%
Spot Rate USD/JPY = 120.10
Use the formula 4) to get 3 months Forward Rate (F),
SR = F - S = 120.1 X {(0.001 - 0.035) X 90/360} / (1 + 0.035 X 90/360) = -1.02
Therefore, 90 days Forward Rate (F) is S + SR = 120.10 + (-1.02) = 119.08
cf) If to use the simplified formula 5),
SR = F - S = 120.1 X {0.001 - 0.035) X 90/360} = -1.03
F = S + SR = 120.10 + (-1.03) = 119.07
Therefore, there will be no big difference in the result when using the formal formula and that of the case when using the simplified formula.
- Benefits from FX Swap
- - Fundraising / financing through FX trading
·By doing buying and selling transactions simultaneously, of which maturity is not matching, can result in same effect of raising or financing the fund in other currency by one currency - - Balance the mismatching fund maturity
·In the case when the maturity of the fund currency between the raised and the financed is not matching, can balance the mismatch by matching their maturities through FX Swap - - Speculation
·Speculation to enjoy FX gain is possible through a prediction of the changes in the future market situation
