Currency swap and Interest rate swap
Forward transaction are either outright or currency swap An outright involves forward purchase or sale of a currency at a forward rate which express the actual price of one currency against another for delivery on specified value date. Forward rate are quoted as outright because it is easily understood by the customers and officials working in the forex departments. However, as transactions pick up and exchange rates become more responsive to the changes in the international markets, it will be convenient to use margin in forward quotations. Besides, it is the margin which is more relevant in the swap market.
A currency swap, which is common in developed market involves purchase or sale of a currency spot with a reverse deal in the forward market or simultaneous purchase and sale of forward currencies with different maturities. The difference between the two is called swap margin or swap rate. The swap transactions are normally done by banks to cover their own exchange risks.
In short we can say under a swap deal the bank buys and sells specified foreign currency simultaneously for different maturities. Thus swap deal may involve:
1. Simultaneous purchase of spot and sale of forward or vice versa.
2. Simultaneous purchase and sale , both forward but for different maturities. For instance, the bank may buy one month forward and sells two months forward. Such a deal is known as ‘forward to forward swap’.
A swap deal is done in the market at a difference from the ordinary deals. In the ordinary deal the following factors enter into the rates:
1. The difference between the buying and selling rates.
2. The forward margin, i.e. the premium or discount.
In the currency swap deal the first is ignored and both buying and selling are done at the same rate. Only the foreword margin enters into the deal as swap difference. In other words the swap rate is the difference between the rate of exchange used in the two trades. A bank may for instance, sell US$1 million against Yen 60.30 million spot value coupled with the purchase of US$ 1.00 million for delivery in 3 months time against Yen 60.50 million. Here the dollar is sold forward at the rate of US$1.00 = Yen 60.30 and forward purchase is at Yen 60.50 the swap rate is 0.20 or 2000 points.
