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Forex swap, being simultaneous borrowing and lending in two currencies, is a
cash management tool. It is the forex-equivalent of repo in money market.
The working cash balances for forex operations are held in what is called
nostro account (see Box 7-1) with another bank (“nostro agent” or “correspon-
dent bank”) in the country of the currency. How do we fund the nostro account
with working balances? There are three ways: buy the foreign currency with
local currency, borrow the foreign currency and do a B-S swap in foreign cur-
rency against the local currency. The first is dangerous, the second is possible
but not efficient, and the third is the practical and efficient solution.
Buying the foreign currency for funding nostro account is ruled out because
it creates long/overbought position, exposing us to currency risk. Borrowing the
foreign currency does not create position and therefore acceptable, but the
problems is the availability of credit lines. The fact that we can borrow from on-
ly those with whom we have the credit line restricts the counterparties from
whom we can borrow. There is also narrow scope for rate negotiation since in-
terest rates are counterparty-specific, unlike asset prices, which are uniform for
all market participants. Forex swap is a collateralized borrowing and therefore
can be executed with every market participant on finer terms.
Consider now the “float” (i.e. temporary surplus funds) in the nostro ac-
count. We have three alternatives to use the float funds: sell the currency, lend
the currency or S-B swap the currency. The first creates position and therefore
is risky; the second creates credit risk and therefore we will be selective about
the borrower; and the third creates neither price risk nor credit risk.
BOX 7-1: Nostro, Vostro and Loro Accounts
Nostro is Italian for “our” and therefore nostro account is simply “our” ac-
count maintained with the nostro agent. When you refer to this account in
correspondence with the nostro agent, you say nostro account (and not
“our nostro” account, which is tautological). When the nostro agent rep-
lies, he would refer to the account as vostro (Italian for “your”) account.
When the same nostro agent also maintains a local currency account
with you in a reciprocal relationship, there could be potential confusion:
your account with him is nostro for you and vostro for him; and his account
with you is vostro for you and nostro for him.
The loro (Italian for “their”) account is a third party‟s account with the
nostro agent. You will use it when referring to a third party‟s account with
the nostro agent.
Why Italian words? Like forex money-changing (see Box 6-1), the
modern banking institutions were established by Italians in the city-states
of Genoa, Venice and Florence during the fifteenth century.
Forex swaps are required to support most commercial transactions. For
example, bills under import letter of credit (L/C) will be debited to the nostro
account before they are retired by the importer-customer. Until the retirement
of the bill, the nostro debit has to be funded through B-S swap in the currency
of nostro account. Similarly, foreign currency bills discounted by the bank are
paid prior to or later than the expected due date. In all such cases, forex swap
becomes handy to adjust the gap in cash flows. We will examine those cases
with examples in the next chapter.
Key Concepts Introduced
Forex swap is simultaneous borrowing and lending in two currencies: it is the
forex equivalent of repo in money market.
Forex swap is a cash management tool, not a risk management tool.
The actions or market sides of forex swap are buy-sell (B-S) and sell-buy (S-
B), which correspond to borrowing and lending, respectively. Since every forex
trade has two currencies in a complementary way, the B-S in one currency is
also S-B in the other for equivalent amount.
The difference in the price of near leg and far leg is the swap points, which
represents the net interest amount payable or receivable in the swap. This dif-
ference is expressed in the same style as forex price: amount of quoting cur-
rency per unit of base currency.
An aide memoire for operations on two-way swap quote is “1=1=1=1.”
The following are the market quotes for spot price and swap points.
1. In the following trades, specify: (1) the swap points for the trade; (2)
whether the swap points are “paid” or “received”; and (3) the prices for the
near leg and far leg of swap. Note that “You” = Asker and “Market” = Quo-
ter in the following questions.
A. EUR/USD: S-B swap in EUR for C/S period
B. EUR/USD: B-S swap in EUR for S/3M period
C. EUR/USD: B-S swap in EUR for 1M/3M period
D. EUR/USD: S-B swap in USD for 2M/6M period
E. AUD/USD: S-B swap in USD for S/6M period
F. AUD/USD: B-S swap in AUD for C/S period
G. AUD/USD: S-B swap in AUD for 2M/6M period
H. USD/JPY: S-B swap in JPY for S/6M period
I. USD/JPY: B-S swap in USD for C/S period
J. USD/JPY: B-S swap in JPY for 3M/6M period
K. USD/JPY: S-B swap in USD for 2M/4M period
L. USD/JPY: S-B swap in JPY for S/45 days period
M. USD/CHF: B-S swap in CHF for C/S period
N. USD/CHF: S-B swap in CHF for C/S period
O. USD/CHF: S-B swap in USD for C/S period
P. USD/CHF: B-S swap in USD for C/S period
Q. USD/CHF: B-S swap in CHF for 2M/3M period
R. USD/CHF: B-S swap in USD for 1M/3M period
2. Using the underlying rates given before, compute the two-way quote for
swap points for the following cross rates and for the following periods.
Investment banking business will increase its focus on client and flow trading
businesses… and exit certain proprietary and principal trading activities. (Cre-
dit Suisse, press release, December 4, 2008, Zurich)
Deutsche Bank said…it planned to scale back proprietary trading, while invest-
ing more in “flow” trading…Other banks have weighed or started cuts in pro-
prietary trading, including J P Morgan Chase & Co, the largest US bank by
market value, which is shutting a stand-alone global proprietary trading desk.
(Bloomberg, December 12, 2008, New York)
Forex trades in a bank are accounted in two separate books: proprietary
(“prop”) trading and commercial transactions. Proprietary trading is euphemism
for speculation in which bank maintains a position, which results in profit or
loss. For these transactions, bank does not need a customer: it deals with
another dealer in the market.
Customer transactions are those initiated with customers. The bank is not
exposed to market risk on these transactions, but rather earns margin or
spread or both. If the products are highly standardized, common place and off-
the-shelf (“commoditized”) and the market is competitive, the margins are thin
and the bid-offer spread is the primary source of profits. Such customer trans-
actions are called flow trading in which the customer is evolved from client to
counterparty. In fixed-income securities (and institutional equities), where the
market is very competitive because of the presence of investment banks and
brokers in addition to commercial banks, much of the customer business is
flow trading. If the products are customized or the market is not very competi-
tive, banks earn margin in addition to bid-offer spread. Such transactions are
called commercial or merchant transactions. At the present stage, much of the
customer business in the OTC forex market is commercial, with the flow trad-
ing restricted to interdealer business between active and inactive dealers.
Proprietary (“prop”) trading was the fashion in Sales & Trading units of big
banks during the 2000s until the subprime crisis blew it up in 2008. Bitten by
the excessive greed and reckless risk-taking, most banks are now re-focusing
on customer transactions, as evidenced by the quotations at the beginning of
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