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Swaps in Forex Markets

Swaps in Forex Markets

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Published by skyscrapper

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Published by: skyscrapper on Aug 16, 2010
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Thus in the USD/CHF case, 0.0015 must be added to or subtracted from the
spot bid rate of 1.4265 & 0.0008 must be added to or subtracted from the spot
ask rate 1.4275

How does one know whether to add or subtract in a given case?
The following two principles have to be kept in mind:

1. The bank must always make profit, i .e. the rate at which bank sells a
currency must exceed the rate at which it buys the same currency.
Hence outright forward ask rate must exceed the bid rate.

2. As a general rule, the bid-ask spread widens with time. It is narrowest
for spot, narrower for 1-month forward than for 3-month forward & so
forth. The reason as maturity increases, the volume of turnover declines
& counter party credit risk increases.

In the above example suppose the swap points are added: The following
emerges USD/CHF 1-month forward: 1.4280/1.4283. This violates the 2 nd
principle. Sometimes the mistake will be more obvious.

If the spot quote had been 1.4265 / 1.4270, adding the swap points would give
a forward quote of 1.4280/1.4278, which violates the 1st principle.

Taking another example, USD/CAD Spot: 1.2275 / 1.2282 3-month swap :
25/30 If we subtract, we get a 3-month forward of 1.2250 / 1.2252 which
violates the widening of spreads rule; If we add we get 1.2300/ 1.2312 which
satisfies both the requirements.

The difference between the two examples: In the USD/CHF case, the swap quotation was 15/8, a larger number followed by a smaller number; in the USD/CAD case it was 25/30, a smaller number followed by a larger number.

Rule to compute outright forwards implied by a swap quotation:
Spot rate (B/A): Bid Rate for B/Ask Rate for B. Units of A per unit of B. A is the
quoted currency, B is the base currency.
If swap points are: Low/ High, Add swap points. Quoted currency A at a
discount; Base currency B at a premium.
If swap points are: High / Low, Subtract swap points. Quoted currency A at
premium; Base currency B at discount.

This rule is conditional upon our convention for quoting rates (B/A), viz. rates
are given as units of A per unit of B, bid followed by ask, bid is for the bank
buying currency B & ask is for bank selling currency B.

Following these rules, the EUR/JPY outright forwards would be
(124.55  2.30) / (124.65  2.20) = 122.25 / 122.45
If a forward swap quote includes the word par it means that the spot rate &
the forward outright rate are the same. Par in this case means zero.

Suppose we have the following quote from a bank: USD/CAD Spot: 1.6560/70
2-month swap: 15/20. A customer will sell US $ spot & buy US $ 2 months
forward against Canadian dollars i. e. Bank buys spot & sells forward.

USD/CHF Spot: 1.6225/30 182 day swap: 35/20
What is the outright USD/CHF 182 day rate? Is the CHF at discount or

USD/CAD Spot: 1.2745/55 1 month swap: 5/10
What is the 1 month outright rate? Which currency is at premium?
A firm wants a swap in which it will buy USD spot & sell USD 1 month forward.

The bank & the firm agree to a spot of 1.2750 CAD per USD. What will be rate
applicable to the forward leg of the transaction?
Short- Date Contracts

Short date transactions are those in which value date is before the spot value
date. For instance, it is possible to do a £/$ deal for a delivery same da y
because the 5-6 hour delay between New York & London allows instructions to
be transmitted to & processed in NY. A $/¥ deal for the same day would not be
possible because by the time NY opens for business, Tokyo is closed.

Broken Date Contracts

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