Its name suggests what a currency swap is all about. It is a transaction in which the principal and interest in one foreign currency is exchanged for the principal and interest in another foreign currency. For example, if one company needs US dollars and another company requires French francs, then all that is required is for the two companies to agree on an interest rate, the amount to be exchanged, and the date on which the funds would mature. Such maturities are a flexible medium of trading in foreign exchange since they have at least a timeframe of 10 years in which they can be negotiated. Currency swaps are not instruments that are traded in formal Exchanges, but are contracts which private parties like financial institutions, customize between them and trade over-the-counter.

The Purpose of Currency Swaps

A currency swap is quite legal, even though it is one transaction dealing with foreign exchange that the law does not require a company to report on its balance sheet. For this reason they were originally used to circumvent exchange controls.

A currency swap can be priced at a ‘fair fixed rate’ by making its value equal to zero at the commencement of the transaction, so that the present value of both expected cash flows are equal. This effectively allows the market participant the flexibility to pay or receive either the fixed rate, or one that can fluctuate, over a period of time. These cash flows can be netted, which is one way of reducing the credit exposure of the transacting parties, so that both settlement and pre-settlement risks are covered. Credit exposure is examined when the credit risk of counterparties is being assessed, since there are many uncertainties involved in foreign exchange transactions, in general, and currency swaps in particular.

As suggested, foreign currency is traded within the financial market. Investopedia and Barron’s Dictionaries, and Wikipedia all seem to agree that a foreign exchange option is a contract. This contract involves persons who are owners, holders, sellers, buyers, or brokers, and who have the right, but are not obligated, to buy or sell foreign currency at a specified rate or fixed price within a specific timeframe or on a particular date. This is dependent on whether American-style options or European-style options are being exercised. The buyer pays the broker a premium for this right. Trading can be done over-the-counter, where there is light regulation, or more formally on established exchanges like the International Securities Exchange.

Markus Cekan and Armin Wendel, two German researchers, mention Exotic Options, as against Plain Vanilla Options. They state that Exotic Options, which entered the market during the 1990s, can be either First Generation or Second Generation, although the distinction between them is subjectively dependent on who is in charge of trading. Exotics quote the bid and ask prices of a product in live currency trading, while Plain Vanilla Options are traded through automated systems.

The Importance of Foreign Exchange Options

Foreign exchange options are understood, in finance, to be currency options. Since exchange rates are volatile, currency options are used by individuals and companies to protect themselves against fluctuations that might possibly result in financial loss. This is called hedging, and operates where future foreign cash flows are uncertain. Investors use these options to hedge themselves by purchasing a currency call option or put option. With a call option, investors can purchase an asset at a pre-arranged price on a specified date or before that date arrives, while a put option enables an investor to sell an asset with the same arrangement.

Forex swap is the contracted way of saying foreign exchange swap, and is an investment tactic where the same amount is both bought and sold in one currency, while simultaneously purchasing another currency which has two value dates that are different. This is a prudent move since in that situation the investor balances the sale and the purchase against each other, which puts him in a position to make a profit in both the short-term and over a longer period.

Inherent in the forex swap is a two-part process that impacts the foreign exchange balances an investor holds. The first component is called a spot foreign exchange transaction and usually has an immediate delivery date. The second feature, a forward foreign exchange transaction, enables an investor to realize a profit in the long run. A forex swap should not be confused with a currency trade, which is simply exchanging one currency for another that is performing better.

The Effect of the Forex Swap

Since the forex swap involves dual currencies, its double nature allows an investor to be in a long position in one currency and a short position in the other. The long position is the favored one as it attracts interest for the investor over a long period. Success, however, is dependent on whether the trader can evaluate market movements to accurately predict the currency position’s yield or cost. The volatile nature of foreign exchange trading, as opposed to that of stocks and bonds, necessitates the constant monitoring of any events which could impact the currency’s value in a negative way. This is therefore not an activity for novice traders. Beginning investors would be wise to gain experience by trying the forex swap in stable currency in order to master the strategy and maximize earning potential.