International Business

What are Swap and Deposit Transactions in Foreign Exchange

A ‘swap deal’ is a transaction in which the bank buys and sells the specified foreign currency simultaneously for different maturities. Thus a swap deal may involve.

(i) Simultaneous purchase of spot and sale of forward or vice versa; or

(ii) Simultaneous purchase and sale, both forward but for different maturities. For instance, the bank may buy one month forward and sell two months forward. Such a deal is known as ‘forward to forward swap’.

Need for Swap Deals. Some of the cases where swap deal may become necessary are described below:

(i) When the bank enters into a forward deal for a large amount with the customer and cannot find a suitable forward cover deal in the market, recourse to swap deal may become necessary. For example, the bank has bought two months forward from a customer French Francs 1.5 million.

If the bank is unable to find a buyer in the market for two months forward for the currency, it cannot wait till it finds one because the rate may change adversely. To cover the exchange risk, it will sell spot in the market. Let us say that the market rate is Rs. 5.82-5.86 spot and 2 months forward discount is 3 paise. The bank would have quoted a rate something less than Rs. 5.79, say Rs. 5.78. The bank sells spot to the market buying rate of Rs. 5.82. The position of the bank is:

(i) Spot sale FF 1.5 million at Rs. 5.82; and

(ii) Forward purchase FF 1.5 million at Rs. 7.78.

The above deals cover the exchange risk for the bank. But the spot sale would result in an overdraft in the bank’s account maintained abroad. Therefore, the bank has to make spot purchase to fund the account. The next day, the bank carries out a swap buying spot and selling forward. If in the meanwhile, the rate has moved to Rs. 5.80-5.84 and the forward margin is 3 paise discount, the bank would be able to buy spot at Rs. 5.80 and sell forward at Rs. 5.77.

It may be noted that under the swap deal the movement of the spot rate does not affect the bank. It the bank could have found cover in the market for forward on the date of purchase from the customer, it could have sold two months forward to the market at the market buying rate of Its. 5.79. Having purchased from the customer at Rs. 5.78, the profit to the bank would have been 1 paisa per franc.

Under the swap deal too, the combined effect of all the four transactions results in a profit of 1 paisa per franc to the bank.

The net difference is 1 paisa in favor of the bank. Had the bank waited for the next day, it could have sold forward at the market buying rate of Rs. 5.77. The net result would be a loss of 1 paisa per franc to the bank.

(ii) Swap may be needed when early delivery or extension of forward contracts is effected at the request of the customers.

(iii) Swap may be carried out to adjust cash position in a currency.

(iv) Swap may also be carried out when the bank is overbought for certain maturities and oversold for certain other maturities in a currency.

Swap and Deposit/Investment

Let us suppose that the bank sells USD 10,000 three months forward. Instead of covering its position by a forward purchase, the bank may buy from the market spot dollar and keep the amount in deposit with a bank in New York. The deposit will be for a period of three months. On maturity the deposit will be utilized to meet its forward sale commitment. Such a transaction in known as ‘swap and deposit’.

The bank may resort to this method if the interest rate at New York is sufficiently higher than that prevailing in the local market. If, instead of keeping the amount in deposit with a New York bank in the above case, the spot dollar purchased is invested in some other securities, the transaction is known as ‘swap and investment’.

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