What are Forex Swaps?

When a forex trader says they have just done a “swap” or have “swapped” their trading position with an online forex broker or forward desk market maker, they are usually referring to having executed a two part transaction in which they closed out a forex position for one value date and opened one of a similar magnitude for another value date.

Alternatively, when a forex trader asks for “the swap” or a quote for swapping a position from one maturity date to another, they are probably referring to the number of pips they will have to pay away or will receive for swapping a forex position between those value dates.

Furthermore, in a forex swap transaction, the first value date to arrive is typically called the “near date”, while the second value date to arrive will be termed the “far date”.

Swap Points

The number of forex pips or points associated with doing a swap depends on the interest rate differential in effect for money market deposits that exists between the two currencies involved in the currency pair being transacted.

These are usually known as swap points and are objectively calculated using the principle of interest rate parity. Nevertheless, supply and demand effects can move the swap points on occasion due to large transactions, as can a sudden shift in expectations for future interest rate levels.

In a swap transaction, the eventual holder of the higher interest rate currency and the current holder of the low interest rate currency will usually receive the swap points to compensate them for holding a lower yielding currency. On the other hand, the eventual holder of the lower interest rate currency and the current holder of the higher interest rate currency will typically pay out the swap points.

Swap Dealing Spreads

Swaps are also generally subject to another form of transaction cost imposed by the forward desk’s market maker or online forex broker. This extra cost is known as the swap bid offer or dealing spread.

Such dealing spreads are usually very tight for short term swaps like tom next rollovers, but they tend to widen as swaps extend in their final maturity dates. The spread helps compensate the market maker for handling the swap transaction and placing it in their forward book.

Using Swaps Strategically

To minimize transaction costs arising from swaps, most forex traders holding long term positions will swap out their positions to a date corresponding to their anticipated trading horizon for closing out this position.

Traders who might use this strategy include trend traders who can hold positions until a substantial anticipated market movement has occurred. Such traders might either receive or pay away the swap points, depending on their long term directional view for the currency pair.

An example of another type of forex trader that uses forex swaps might be a carry trader. A carry trader will typically establish foreign exchange positions where they are long the higher interest rate currency and short the lower interest rate currency.

Carry traders usually also expect the higher interest rate currency to appreciate in value relative to the lower rate currency over their anticipated carry trade horizon. Such traders will generally only receive swap points when they swap out a carry trade position since their main objective is to profit from the interest rate differential.

Still another usage of swap transactions is usually done by hedgers who need to match out currency cash flows. For example, if they have some foreign currency coming in soon, but will only need it in a few months time, then they might elect to swap out the foreign currency by selling it for the near date and simultaneously buying it for the far date when they anticipate needing it.