Foreign exchange swap
Also written FX swap · Forex swap · Buy-sell swap · Sell-buy swap
An OTC derivative in which two currencies are actually exchanged on one date (the short leg) and re-exchanged at a later date (the long leg), at rates agreed at the time of the contract.
In plain language
A bank has rupees today and needs dollars today, but it will have dollars again next month and will want rupees back. It does not want to take a currency view. It just has a timing mismatch.
A foreign exchange swap solves exactly that. Two currencies are exchanged now, and the same two currencies are exchanged back later. Both rates are fixed at the start.
The workbook's definition names the parts: an OTC derivative involving the actual exchange of two currencies — principal amount only — on a specified date (the short leg) and a reverse exchange of the same two currencies at a date further in the future (the long leg), at rates agreed at the time of the contract.
Three things follow.
Principal only. No interest streams change hands, unlike a currency swap.
Two dates, two rates. The near rate and the far rate are both agreed on day one, so the difference between them is known from the start.
No net currency view. Because you sell and then buy back, you are not left long or short the currency. What you have swapped is the funding, not the exposure.
This is the largest FX product in the world. The workbook's BIS table puts daily turnover in FX swaps at USD 3,810 billion — more than spot and outright forwards combined.
How it works
The definition (Chapter 2, section 2.3.4). A foreign exchange swap means an OTC derivative involving the actual exchange of two currencies (principal amount only) on a specified date (the short leg) and a reverse exchange of the same two currencies at a date further in the future (the long leg), at rates agreed at the time of the contract. The workbook's own illustration has the spot rate for the short leg at Rs 73 and the rate agreed for the long leg at Rs 73.50.
Against its cousin. The workbook says the two forex swaps are basically the same but there are slight differences:
| Foreign exchange swap | Currency swap | |
|---|---|---|
| What is exchanged | Principal only, once now and reversed later | Streams of interest payments and/or principal in different currencies on specified dates |
| Number of exchanges | Two — short leg, long leg | Several, over the duration of the swap |
| Rate | Rates for both legs agreed at inception | A pre-agreed exchange rate locked for the entire tenure |
| Typical use | Short-term funding, rolling a position | Long-term foreign currency borrowing |
| Also called | — | Cross currency swap |
Where it sits in the market. From the BIS Triennial Central Bank Survey 2022 reproduced in Chapter 1, daily averages in USD billions:
| Instrument | Daily turnover |
|---|---|
| Spot transactions | 2,104 |
| Outright forwards | 1,163 |
| Foreign exchange swaps | 3,810 |
| Currency swaps | 124 |
| FX options and other | 304 |
| Total OTC FX turnover | 7,506 |
| Exchange traded derivatives | 154 |
The workbook draws the conclusion itself: growth of FX derivatives trading, especially in FX swaps, outpaced that of spot trading. Note also the ratio — FX swaps are roughly 31 times the size of currency swaps.
The Indian plumbing.
- Forex trading in India takes place OTC, including on electronic trading platforms, for spot, forward and swaps.
- Forex swaps are largely transacted outside a platform, on a bilateral basis — the major interbank spot venues, Refinitiv D2 and FX Clear, are not where swaps get done.
- CCIL offers CCP services for settlement with trade guarantee for USDINR forward contracts and USDINR swap contracts.
- A foreign exchange swap is an OTC product. Chapter 2's sample question asks which contracts are traded only on exchanges, and FX swaps are not among them — currency futures are.
A worked example
The workbook's two legs. The spot rate for the short leg is Rs 73 and the agreed rate for the long leg is Rs 73.50.
A bank swaps USD 10 million against rupees.
| Leg | Date | Direction | Rate | Rupees |
|---|---|---|---|---|
| Short leg | Now | Bank buys USD 10 mn, pays INR | 73.00 | Rs 73,00,00,000 out |
| Long leg | Later | Bank sells USD 10 mn, receives INR | 73.50 | Rs 73,50,00,000 in |
| Net | 0.50 a dollar | Rs 50,00,000 gain |
That Rs 50 lakh is not a currency profit. It is the swap difference, known on day one, and it is the price of borrowing dollars against rupees for that period. Both rates were fixed at the start, so there is no exchange rate risk in the swap at all — the bank ends with the same USD 10 million position it started with.
Why the bank did it. Suppose it needed dollars for a month to fund a client payment, and had rupees.
| Alternative | Problem |
|---|---|
| Buy USD 10 mn spot and sell it back in a month at whatever rate then prevails | Leaves a one-month currency exposure |
| Borrow dollars in the interbank market | May be dearer, and uses credit lines |
| FX swap | Gets the dollars now, returns them at a known rate — funding solved, exposure untouched |
Contrast with a currency swap on the same USD 10 million. Using the workbook's currency swap example, which runs at a spot rate of Rs 74.
| FX swap | Currency swap | |
|---|---|---|
| Cash flows | 2 — principal out, principal back | Many — USD floating interest and USD principal amortisations received, INR fixed interest and equivalent INR principal amortisations paid |
| Interest exchanged | None | Yes, on every payment date |
| Tenure | Short | Matches a long-term borrowing |
| Rate | 73.00 and 73.50 | Rs 74 locked for the entire tenure |
And note the scale difference the BIS table gives: USD 3,810 billion a day in FX swaps against USD 124 billion in currency swaps.
Why NISM asks about it
Chapter 2, section 2.3.4 (Swaps), gives the definition, the Rs 73 / Rs 73.50 illustration and the comparison with currency swaps; Chapter 1, section 1.2.2, carries the BIS turnover table with the USD 3,810 billion figure and the note that FX swap growth outpaced spot; sections 1.3.3 and 1.3.8 record that forex swaps are largely transacted bilaterally off-platform. Chapter 2's sample question on which contracts trade only on exchanges uses FX swaps as a distractor. Expect a question on the short leg / long leg structure, on principal only, or on the FX-swap-versus-currency-swap distinction.
Common exam traps
- Principal only. A foreign exchange swap exchanges principal and re-exchanges it; it does not exchange interest streams. That is the currency swap.
- Short leg first, long leg later, and both rates are agreed at inception. Neither leg is left to the market.
- An FX swap leaves no net currency position. It swaps funding, not exposure — so it is not a way to take a view on the rupee.
- FX swaps are OTC and not listed on Indian exchanges. Only currency futures and options trade on the exchanges.
- FX swaps are the largest FX instrument by turnover — USD 3,810 billion a day — and roughly 31 times the size of currency swaps. Candidates routinely assume spot is the biggest; it is not.
- Currency swap is also called cross currency swap. "Foreign exchange swap" is not another name for it, even though the workbook says the two are basically the same.
- CCIL clears USDINR swap contracts as a CCP. So an FX swap in India is OTC but not necessarily bilaterally settled.
Check yourself
1.What distinguishes a foreign exchange swap from a currency swap?
- a)The FX swap is exchange-traded while the currency swap is OTC
- b)The FX swap exchanges principal only, in a short leg and a reverse long leg; the currency swap exchanges streams of interest payments and/or principal over the swap's duration
- c)The FX swap involves only one currency
- d)They are identical in every respect
Show the answer
Answer: (b) The FX swap exchanges principal only, in a short leg and a reverse long leg; the currency swap exchanges streams of interest payments and/or principal over the swap's duration
The workbook flags them as close but distinct: in forex market there are two kinds of swaps namely, foreign exchange swap and currency swap. The two are basically the same but there are slight differences.
'Foreign exchange swap' means an OTC derivative involving the actual exchange of two currencies (principal amount only) on a specified date (the short leg) and a reverse exchange of the same two currencies at a date further in the future (the long leg), at rates agreed at the time of the contract.
In the illustration, the spot rate for the short leg is Rs.73 while the rate agreed upon for the long leg is Rs.73.50.
'Currency swap' (also known as cross currency swap) means an OTC derivative which commits two counterparties to exchange streams of interest payments and/or principal amounts in different currencies on specified dates over the duration of the swap at a pre-agreed exchange rate.
Principal only across two dates, versus interest streams and principal across a whole tenure.
Option A is wrong on both counts — both are OTC derivatives by definition, and the summary table records swaps as mainly OTC.
Option C misreads the product. Both involve two currencies; that is what makes them foreign exchange instruments.
Why a borrower would use a currency swap: a customer in India with a long-term USD borrowing is typically exposed to exchange rate risk between the USD and the INR as well as USD interest rate risk. By swapping, the customer receives from the bank USD floating interest rate payments and USD principal amortisations. Simultaneously, the customer pays the bank fixed interest rate in INR and the equivalent INR principal amortisations at an exchange rate based on a spot rate (or forward rate)... locked in for the entire tenure of the swap.
One detail: at the start, initial principal is exchanged, though not obligatory.
And the general nature of swaps: swaps are, broadly speaking, a series of forward contracts.
2.Which of the following derivative contracts is traded only on exchanges?
- a)Currency futures
- b)Currency options
- c)Currency swaps
- d)FX swaps
Show the answer
Answer: (a) Currency futures
Futures alone is exchange-only.
The workbook's summary table gives the market for each generic derivative: Forward — OTC · Futures — Exchange · Swap — Mainly OTC · Option — OTC and Exchange.
And the definition builds the exchange in: Currency Futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract.
Option B is wrong because options trade in both venues — Options are traded both OTC as well as on Exchanges, as Chapter 1 also noted while listing where each Indian product trades.
Options C and D are both OTC. 'Foreign exchange swap' means an OTC derivative involving the actual exchange of two currencies (principal amount only)... and 'Currency swap' (also known as cross currency swap) means an OTC derivative which commits two counterparties to exchange streams of interest payments and/or principal amounts in different currencies.
What being exchange-traded brings: the futures contracts are standardized in terms of lot size, underlying, expiry date etc. Contracts are mainly settled in cash... Margins and mark to market are applicable for such contracts. Settlement guarantee is provided by the clearing corporation of the Exchanges.
And how that guarantee is created: the trade guarantee is provided by Clearing Corporation becoming a common party, called central counterparty (CCP), to the buyer and seller through the process of novation — so that Clearing Corporation becomes the buyer to the seller; and the seller to the buyer.
Where this is taught
Free preparation for NISM Series IRelated terms
- Currency swapAn OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
- Foreign exchange derivative contractUnder the FEMA regulations, a financial contract that derives its value from a change in the exchange rate of two currencies, at least one of which is not the rupee, and settles later than the spot date.
- Foreign exchange forwardAn OTC derivative involving the exchange of two currencies on a specified future date more than two business days away, at a rate agreed on the date of the contract.
- Interest rate swapAn agreement to exchange streams of interest payments on a notional principal for a set period — typically fixed against floating — where only the net difference ever changes hands.
- CCILThe Clearing Corporation of India Ltd, the central counterparty that guarantees settlement of government securities, repo and OTC interest rate derivative trades by novation.
- Over-the-counterA bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.
- Cross currency swapAn OTC agreement to exchange floating-rate payments in one currency for floating-rate payments in another, with principal typically exchanged at both the start and end, used to hedge foreign-currency portfolio exposure.