Fx Swap

A small overview on fx swaps:

Swaps is an agreement to exchange cash flows. So say I (Bank A) have surplus USDs and I need INR. However, Bank B is in the exact opposite situation. So Bank A can swap cash flows with bank B.

I will give out the surplus USDs in exchange for INR and Bank B will do the vice versa with an agreement to swap out the cash flow at the end of the term.

USDINR spot 76.00

USD Rate 0.50%

INR Rate 4.00%

Tenor 1 year

The transaction can also be thought of in terms of buying and selling of money market instrument. So say I buy USD security, I will give out USD to you and receive interest on USD. I sell INR security and receive INR funds and pay out the interest to you.

Basically, interest rate parity is a fundamental concept linking the exchange rate to the interest rate. It defines a no arbitrage condition, wherein my hedged returns are same whether I invest in a USD security and convert it to INR or invest in an INR security and convert it to USDs.

For example, I buy USD 1 mio of US treasuries that are yielding 0.50%. At the end of the period, maturity amount is 1,005,000. I enter into an agreement to sell USD forward and get INR. So I receive 79.04 crs. Alternately, if I invest 7.6 crs in INR security, maturity amount is 79.04 crs. I enter into an agreement to buy USD forward, the USD notional will be equal to 1,005,000.

USDINR forward rate = USDINR spot * (1+inr rate(*price currency))/(1+usd rate(*base currency))

78.6467 = 76.00 * (1+4%)/(1+0.50%)

Swap points = 78.6467 - 76.00 = 2.6467

Generally, the thumb rule is currency with a lower interest trades at a premium.

Now I have generally seen people get confused if the fx swap rates should be positive or negative.

If you can have in mind the interest rate and visualize the equation , it should do the trick.

Now current interest rate is not the only driver of forward rates. Interest rate expectations, demand supply of currencies will also have an important bearing. On that in the later post.

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