6. The Forward & Swap Market

Question 1

What is the FX forward market?

Answer 1

• sellers & buyers transact convertible currencies for delivery in the future where the settlement date is after spot.
• allows FX trades to be settled anywhere from after spot date to several years.

Question 2

What are the benefits of FX forward market?

Answer 2

• traders can hedge their forward currency exposure risks.
• banks can arbitrage & speculate/take positions in the forward market.
• central banks can implement currency’s interventions.
• FX forward transactions are normally up to one year — use ‘fixed-delivery’ forwards & forward option delivery contracts to hedge exposure risks.

Question 3

What does FX spot rate & forward rate reflects?

Answer 3

• spot rate: reflects what the market deems is the ‘right’ value at spot date
• forward rate: represents the interest differential between 2 currencies over the forward period.
• Other factors like market sentiments (eg: devaluation & revaluation expectations), technical supply/demand, year-end liquidity & seasonal factors & central bank intervention also affect the forward value between 2 currencies.

Question 4

What is interest differential?

Answer 4

converted into ‘forward swap points’ which will be added/deducted from the prevailing spot rate to arrive at the forward rate.

Question 5

Does forward rates forecast future exchange rates?

Answer 5

No. It merely reflects the interest differential between a currency pair over a specific period

Question 6

What are the 2 main components of forward rate?

Answer 6

spot rate (available in the market) & forward swap points (interest differential between the 2 currencies over the forward period — available in the market)

Question 7

What is all-in FX forward rate?

Answer 7

includes spot rates, swap points & any margin added — quoted to the customers.

Question 8

How to calculate forward FX rate if forward swap points are premium/discount’?

Answer 8

If the forward swap points are at a:
• premium, add the swap points to the prevailing spot rate
• discount, deduct the swap points from the prevailing spot rate
• If there’s 0 interest differential between the 2 currencies = 0 forward swap points.
- forward rate will be at/near ‘par’ = equal/close to the spot rate.

Question 9

which affects the forward rate the most? Is it the movement in the spot rate or the forward swap points?

Answer 9

• spot rate — fluctuates by the seconds/minutes — fluctuations can be large & volatile.
• swap points (interest differentials between 2 currencies over a specific period of time) — move gradually over a period of time.
• Hence, usually movements in spot rates cause forward rates to move (eg: higher spot USD/MYR will lead to a higher forward USD/MYR, and vice versa)
• so when dealers execute forward FX deal, to square the position the dealer must cover the spot FX rate first — By ‘locking-in’ the spot rate, avoids exposure to the volatile spot movement — subsequently goes to the market to execute a swap to lock-in the swap points, thus effectively locks in the forward rate.

Question 10

What are FX swaps?

Answer 10

• exchange 1 currency for another at an agreed exchange rate & date, then re-exchange these 2 currencies on a later date at the agreed exchange rate.
• lending 1 currency & simultaneously borrowing another currency via 2 separate FX transactions — avoid the need to borrow & lend funds
• substitutes for direct money market lending & borrowing operations.

Question 11

What is “forward-forward” FX swap?

Answer 11

first leg of FX swap isn’t on spot date but a forward date

Question 12

What are the basic features of FX swap?

Answer 12

• can be a short-dated (eg: O/N, T/N & 1-week swap), fixed-dated (eg: 3/6-month swaps), medium-term (eg: 2/3-year swaps). BUT most FX swaps are short term (1 year or less)
• the amount of the deal (base) currency is the same, while the other non-deal (term) currency amount varies according to the spot & forward rates.
• difference between the 2 agreed FX rates (one spot & the other forward) are the swap points — reflects the interest rate differential between the 2 currencies for the particular swap period.

Question 13

What are the advantages of FX swaps?

Answer 13

1. reduce exposure to FX risk due to unfavourable movements
2. Reduce Credit Risks
   - lending surplus funds = potential credit risk.
   - borrows funds = using money market limits, reduce liquidity source
   - Since FX swaps are 2 separate FX deals (spot & forward), there’s no ‘outright’ lending/borrowing involved.
   - FX transaction risks (potential settlement & pre-settlement risks) are less risky than money market lending risks.
3. greater cash flow certainty
4. Possible tax advantages
   - swaps don’t result in lending/borrowing = no interest receivables/payables

Question 14

What are the uses of FX swaps?

Answer 14

1. Swap surplus currencies into other currencies
2. create deposit borrowings in another currency.
   - eg: foreign bank operating in Msia which needs to borrow USD can borrow Swiss Francs from its head office (say, in Zurich) & executes buy/sell USD/CHF swap
   - may lead to lower borrowings cost
3. alternative when the cash money market is illiquid/deposit can’t be directly borrowed/lent due to regulations
4. Allows position taking of the movements in the interest differential between 2 currencies — speculative (trader taking a view)
5. Allows the possibility of arbitrage between the swap & cash deposit money market, especially if the currency is regulated/has a 2-tier interest rate structure.
   - true in most domestic currencies; eg: MYR & SGD, due to different costs of maintaining the minimum statutory reserves among banks
6. Enable FX traders to ‘rollover’ their spot FX positions.

Question 15

What are the factors affecting the swap points?

Answer 15

• interest rates, inflation, current account deficits & the exchange rate relative to the economic health of both countries.
• arbitrage opportunity: FX swap rate of 2 currencies must correspond to the actual spot rate & the interest differential. If not traders can profit from arbitrage
• market liquidity: can be observed via swap spreads
• credit: over longer horizons the tenor influence from credit on swap spreads is more significant.

Question 16

What are early-take-up, extensions or cancellation of FX contract & what is the consequences?

Answer 16

1. early-take-up: forward exchange contract is used before the maturity date of the fixed delivery period contract — normally for trade-related transactions
2. Extensions: when funds payment/receipt is deferred, customer may request to extend forward contract maturity date
3. cancellation: customer can’t use the forward exchange contract — outstanding FX forward balance is cancelled by settlement of the difference in FX between the forward contract rate & the prevailing spot FX rate — may cause financial loss to be paid by the customers.

• swap points will be recalculated

Question 17

What is the right method to determine the exact odd-date swap points (especially when determining the longer-dated swap points)?

Answer 17

use the swap formula.

Question 18

What are some of the reasons for extension/cancellation of contracts?

Answer 18

• Non-receipt/delay of incoming funds or proceeds
• Delay in shipment of goods bought/sold
• Inadequate funds to fulfil commitment for payments

normally apply to trade-related transactions based on genuine commercial reasons & NOT for speculative purposes.

Question 19

What’s extension margin & what does it incorporates?

Answer 19

• difference between the original FX contract rate & the new historical contract rate rollover
• it incorporates :
  • applicable forward swap points
  • funding costs if applicable (this charge is associated with funding/borrowing
  that profit or loss for the term of the extension period—interest is calculated in
  advance & translated into swap points).
  • Other fees that may be applicable.

Question 20

How to rollover maturing FX contracts using historical contracted rates?

Answer 20

original rate + adjustments for swap points

Question 21

Extending/rolling over contracts at historical contract rates, especially when repeated several times and when the historical contract rates are moving further from the current spot rates, raise what kind of concerns?

Answer 21

• customer: Possibility of hiding/postponing losses on FX deals
• bank: increase in credit exposure & funding costs may not be realized + when there is a default, the credit exposure may be substantially underestimated.

Question 22

historical contract rate rollovers are generally limited to?

Answer 22

• FX contract loss when marked to market is less than MYR10,000.
• exchange rate at the time of the extension is within a certain margin, eg: +/– 10%
• First time extension/not more than 2 extensions.

Question 23

How to extend forward contracts at current FX rates?

Answer 23

• original FX contract would be cancelled & a new FX contract is established for delivery at a new contract rate & value date.
• Cancellation of the original FX contract requires a spot FX transaction that will off-set the cashflow of the original FX contract — profit/loss depends on how the current exchange rates compare to the original FX rate.
• profit/loss from the cancellation would be realized & the customer’s account is credited/debited with the differences between the original contract rate & the current FX rate.

Question 24

What are some of the possible reasons for cancellations?

Answer 24

• Cancellation of orders
• Failure to deliver/unable to meet orders
• Reduction in orders/changes in orders
• Change in regulations/exchange controls

Question 25

Do exchange contracts need to be closed-out once the underlying trade transactions are no longer in place?

Answer 25

Under the exchange control regulations, yes

Question 26

Does customer need to provide valid reason for the cancellation of FX contract?

Answer 26

Under the exchange control regulations, yes, supported by documentary evidence otherwise, it could be deemed to be a speculative transaction — customer won’t be compensated for gains if contract cancellation is due to speculative transactions.

Question 27

What are FX swaps, and why are they such popular instruments among the international banking community?

Answer 27

involves the swapping of a pair of convertible currencies, i.e., consists of 2 legs, a spot transaction in the first leg followed by a forward transaction in the second leg, which is the reverse of the first leg.

By executing an FX swap, one is lending one currency and at the same time borrowing another currency via two separate FX transactions.

One reason for the popularity of FX swaps is because FX swaps are substitutes for direct money market lending and borrowing operations.

Question 28

Assuming you received a 3-month MYR deposit from a customer, and at the same time, the bank makes a three-month USD loan to another customer.
a) To ‘cover’ both the positions, what are the two options available to the bank?
b) If the trader decides to cover the swap exposure, which of the following three-
month swaps should he execute?
(i) Sell/Buy USD/MYR
(ii) Buy/Sell USD/MYR
(iii) Buy/Buy USD/MYR

Answer 28

a) The 2 options are
i. Square the positions in the money market, i.e. lend out the MYR for 3
months and borrow USD for 3 months also
ii. Use an FX swap

b) Buy/Sell USD/MYR

Question 29

You request a money broker for T/N USD/MYR swap for which it quotes ‘1/1.1’
(a) If you intend to do a sell/buy USD/MYR, which swap rate will you hit?
(b) Will you sell/buy USD/MYR at a premium or discount?

Answer 29

a) Sell/buy USD/MYR T/N swap at 1.1
b) Will sell/buy at a premium

Question 30

You request another bank for a six-month USD/MYR swap for which it quotes ‘170–180’.
(a) If you intend to do a buy/sell USD/MYR, which swap rate will you hit?
(b) Will you buy/sell USD/MYR at a premium or discount?

Answer 30

a) With a buy/sell USD/MYR swap, the second leg is a sell so need to transact at the bid rate of 170.
b) The buy/sell swap will be at a premium