Forex Swaps Explained
As a forex trader, understanding forex swap can protect you against unnecessary losses and could even help make you a few thousand dollars in return.
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As the Wall Street god, Warren Buffet, once said, “When you combine ignorance and leverage, you get some pretty interesting results.” Ignorance is not bliss in forex trading.
In the wild jungle of foreign exchange trading, information is king. A trader needs to understand the markets and all the facets of forex trading to make the most out of it.
Winging it just won’t cut it.
But like most people, the initial few steps might feel impenetrable and overwhelming. Suffocating even! There is infinite information available for beginners to try to navigate at the start – where does one begin? 🤔
So as a beginner and overwhelmed by the tons of information available, you might choose to go in blind. After all, risking a few hundred dollars of your end-of-year bonus might not seem like a big deal, right? However, in this field, it’s very easy to lose everything.
The foreign exchange market is not only the largest trading market globally but also the most actively traded. The actual numbers can be jaw-dropping. According to the latest triennial (three-year) report, global forex trading has reached a whopping $6.6 trillion per day. For context, this amount almost six times more than Canada’s annual Gross Domestic Product (GDP).
But even with the market this big, many investors lose their entire deposits because they don’t understand the essentials of forex trading. But don’t be part of these statistics.
In this guide, we will dissect forex swap. We’ll discuss how it works and how it’s calculated, to make the information much more digestible.
So turn your learning mode on and let us indulge you. 🤓
- What is a Forex Swap?
- Understanding Forex Swaps
- How Does an FX Swap Work
- How to Calculate a Forex Swap Rate
- Currency Swap Trading Strategy
- Cross-Currency and Forex Swaps
- Example of a Forex Swap
- Conclusion
- FAQs
- Get Started with a Forex Broker
What is a Forex Swap? 📚
In online forex trading, a forex swap does not necessarily refer to a physical swap. Instead, a swap, also known as a ‘rollover fee,’ refers to an interest fee gained or paid for keeping a leveraged currency position open overnight. It’s the interest rate differential between two currencies in a trading pair.
There are two types of swaps in forex trading:
Long Swap 🐂
A long swap is an interest earned or charged from holding a long position open overnight. A long position (also known as bullish trade) is when a trader purchases with the expectation that the currency value will increase and they will make a profit from the trade.
Short Swap 🐻
On the other hand, a swap short is an interest earned or charged for holding a short position overnight. A short position (also referred to as bearish trade) is the opposite of a long position. A trader disposes of a currency with the expectation that the currency value will drop.
Forex swaps are measured in pips per lot and vary based on the traded financial instrument.
Understanding Foreign Exchange Swaps 👨🏫
To understand forex swaps, we first need to understand their origin.
The first official forex swap took place between International Business Machines Corporation (IBM) and the World Bank in 1981. At this time, the World Bank urgently needed to acquire more German marks and Swiss francs to fund its overseas operations. Still, due to prohibition by the governments in these two countries, it was not able to borrow locally.
IBM needed to exchange significant amounts of both currencies for U.S. dollars. But the high interest rates at the time served as a hurdle for many corporate borrowers. It’s this situation that gave the Salomon Brothers a million-dollar idea. The two entities can swap their debts.
IBM exchanged its borrowed currencies (the marks and francs9 for the World Bank’s dollars, creating a win-win situation. The World Bank was able to navigate the government restriction, and IBM was able to hedge currency exposure. This simple idea has now become the trillions dollar industry we know today.
So in retrospect, a foreign exchange swap is an agreement between two parties to buy (or sell) currencies at an initial date, then sell (or buy) the same amount of currency upon maturity at an agreed-on rate. 🤝
The agreement consists of swapping principal and interest payments on one loan for principal and interest payments on another loan of equal value. In other words, party A burrows currency from party B while simultaneously lending a different currency to that party.
In a currency swap, both parties continue to pay interest on the swapped principal amounts until maturity. The principal is re-exchanged at a predetermined rate, protecting against both transaction risk and spot price.
Think of this exchange as an educated version of when kids swap their favorite toys at a playdate with their friends and then exchange the toys back during the next playdate. But this time, the toys are rented from a toy vendor, and each kid needs to pay rental fees. So they have to charge each other ‘exchange fees.’ 🧸
These kinds of transactions are mainly used to raise currencies by financial institutions, institutional investors, and even individual exporters and importers.
In the modern world, forex market traders also use forex swaps for speculative trading. Ideally, combining two offsetting positions with different maturity dates.
What Are Forex Swaps Used For? 🧐
From the above, it is clear that forex swaps are a convenient way to obtain loans in foreign currency at more favorable terms than borrowing directly in a foreign market. Additionally, they offer an efficient way to redenominate a loan from one currency to another.
So, a forex swap can be used to:
- ☑ Hedge exchange-rate risk. An FX swap makes it possible to lock in fixed exchange rates for longer, even in unpredictable market situations. For example, investors and businesses with cross-border operations can use forex swaps to shield against currency risks that may create unpredictable profits and losses.
- ☑ To obtain favorable loan rates in a foreign country. Currency swaps offer a cheaper option to borrow foreign monies at more favorable rates than borrowing from the internal market. For example, an American Company with a branch in London wishes to borrow 10M EUR but is subjected to a high-interest rate of 16%. In this case, the Company can enter into an agreement with a European Company (in need of USD) to swap USD/EUR at much lower rates.
- ☑ To hedge government exchange controls. Although most world currencies float freely guided by the market forces of supply and demand, local governments have some level of control through their local central bank. Currency swaps help to maneuver through such exchange controls and government limitations.
There are two main types of currency swaps:
Fixed-for-Fixed 💵
In a fixed-for-fixed swap, both parties agree to pay each other a fixed interest payment on the principal amounts. A fixed-for-fixed swap is advantageous when the interest rate in the other country is cheaper.
Fixed-for-Floating 💸
In this contractual arrangement, one party exchanged fixed interest payments in one currency for floating interest payments in another currency. In this kind of swap, the principal amount of the underlying loan is not exchanged.
There are many reasons why a loan holder would consider a fixed-for-floating swap. First, swapping for a floating rate when the current fixed rate is higher can help lower the overall interest charged, and it is a great edge for when there is an expectation for the market interest rates to drop.
Second, it’s great for matching assets and liabilities that are sensitive to foreign exchange fluctuations. Third, It’s an ingenious way to diversify risk in a portfolio that majorly uses fixed-for-fixed interest rates.
How Does an FX Swap Work? 👷♂️
Now let’s talk about the good stuff!
If a forex trader leaves a position open for more than one trading day, it can result in gains — or interest charges. In other words, they will either win or lose to the broker. Here’s how it works.
After 5 p.m. EST, an open currency position will be held overnight. The swap value can either be positive or negative depending on the swap rate and the position held on the trade. In other words, there are two possible outcomes for holding a currency position overnight; pay or be paid. 🌃
Typically, investors make two trades every time they open a position, selling one currency and buying the other currency in a pair.
In order to sell one of the currencies in a pair, investors ideally “borrow” the money to sell — which is basically a loan — which means they need to pay interest on the amount. A rollover fee is calculated based on the difference between the two currencies’ interest rates.
Suppose Harry buys a currency with a higher underlying interest rate than the currency he’s selling. In that case, he’s likely to earn interest for holding the position overnight and vice versa. The swap rate is pegged on the market and subsequent instruments he trades. For example, a swap for EUR/USD is fundamentally different from that for EUR/AUD.
How much an investor pays or earns for holding a position overnight depends on the instrument traded, the position held, the number of days the position stays open, and the nominal value of the position. Other factors like the broker’s forex commission also contribute to the swap value.
Exchange Rates in Forex Swap 📖
When trading currencies, especially exotic currency pairs, it’s crucial for a trader to fully understand their interest rates and how they are being set.
Currency rates, just like inflation and interest rates, are mainly affected by political upheaval and national economies. For example, the current unrest in Eastern Europe has already had some notable impact on the currency market.
In a free market, the prices are mainly controlled by the law of demand and supply (although taxes and other incentives can also play a role). But it’s not always the case with currencies. Exchange rates can be determined by the market or can be set by governmental institutions.
In this case, exchange rates can be floating or fixed. With a floating exchange rate, the laws of demand and supply apply — the market eventually decides the currency’s value.
The currency’s movements affect things like the local countries’ economy and interest rates, which then enables investors and traders to make money (or earn swaps) by trading with different currencies.
How to Calculate a Forex Swap Rate 🧮
Ideally, swap rates are calculated automatically by the platform; however, a trader can easily calculate their forex swap rate using this formula:
Swap Rate 📜
From the formula above, the first value needed is the swap rate from the formula above. The swap rate is shown on most popular forex trading platforms, and it can be positive or negative depending on the individual currencies’ prevailing interest rates. The value shown is different for long and short positions.
Hence, if a trader places a short position (sell) in the market, then they should use the Swap short rate in their calculation, and if they place a long position (buy), they should use the Swap long rate.
For example, if they’re trading EUR/USD in an FX pair, and on the trading platform, it’s indicated that the Swap long is – 6.13, and Swap short is 0.45. If they’re holding a short position, they will calculate using 0.45.
Swap rates are different for different assets and are measured on a standard size of 1 standard lot (100,000 base units for forex pairs).
Lots (Volume) 🎚
Lots represent the volume of the trade. When a trader places an order in a trading platform, they can choose the volume of their trade — they can choose between a minimum and a maximum number depending on their trading platform.
Number of Nights 📅
This value is as straightforward as it sounds. When calculating a swap rate, a trader must factor in the number of days they held their trading position overnight.
Also, remember triple swap — If a trader keeps their position through the weekend, on Wednesday night, the charges are for three days instead of one.
In cases where the swap rates change from day to day, a trader should calculate each day separately and then add them up.
Example:
Assuming a trader is holding a long position with 5 EUR/USD lots, and they keep the position from Thursday to the following Thursday, here is how to calculate the swap using the above formula:
Swap Rate x No. of Lots (Volume) x No. of Nights = Swap (in base currency)
= 6.13 x 5 x 7
= -214.55 EUR (Positive in trader’s favor)
Currency Swap Trading Strategy 💱
The most common forex swap strategy in forex trading is known as the carry trade. In a carry trade, a trader basically uses a high-yielding currency to fund trade with a low-yielding currency.
Typically, a trader borrows a currency with low-interest rates and uses the money to invest in a currency with high-interest rates. This allows them to earn profit from the difference in the interest of the duo currencies.
A classical example is borrowing Japanese Yen and investing in Swiss Franc (CHF) and the Euro (EUR).
A carry trade strategy is beneficial in a long-term investment strategy and works well if a trader chooses currencies with a significant difference in the exchange rate. However, the inherent risk is that the market fluctuations can potentially reduce their chances of making a huge profit from the daily swaps.
Cross-Currency Swaps and Forex Swaps 📕
Cross-currency swap is often mistaken for forex swap — and for practical reasons, the two are more or less the same.
However, there is a slight difference in that in a forex swap, the two parties exchange a series of cash flows (interest payments and principal) throughout the swap’s life. Interest rates are based on the individual currency index. They can be fixed, variable, or both.
On the other hand, a cross-currency swap involves two transactions; buy/sell at the current spot rate, and sell/buy at the forward rate. In other words, two parties in a trade enter into an agreement to sell each other the same amount in different currencies based on their current individual exchange rates.
After a predetermined period, the parties will then sell the amount back to each other based on the exchange rate spelt out on the forward contract.
Therefore, although both are used to hedge foreign exchange exposure, forex swaps tend to be slightly riskier than cross-currency swaps. In a forex swap, there is a default risk in the event that one party does not meet the scheduled interest payments.
Forex Swaps: An Example 📝
Let’s take a real-life example of a forex swap to make all this information easier to digest.
Let’s assume a trader opens a long swap EUR/AUD position for two lots (200,000 units). In this context, a long position would mean that the trader sells AUD and buys EUR — so the position is now worth $ 200,000.
For this trade, the asking price of EUR/AUD is 1.59. The interest rate between the euro and the Australian dollar is 3.47% and 2.56%, respectively. In this scenario, the trader is much more likely to get a pleasant surprise credited into their trading account.
This is because they’re buying euros (higher interest rate) and selling Australian dollars (lower interest rate).
Conclusion 🏁
Like many other investments, forex trading has its fair share of risks and challenges. You win some, and you lose some. But like Warren Buffet says, there are two fundamental rules: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
Understanding the basics of forex trading is the first step toward winning in this game. That makes learning the industry vital. Thankfully, you’ve taken an important step by reading this article. This guide has covered what forex swaps are, how they work as well as how they are calculated so you can do some math on the side while your money is working for you.
All that is left now is to choose whether you want to take a full dive or go knee-deep to test the waters. Whatever the final decision is, now you know everything there is to know about forex swaps.
Forex Swap: FAQs
-
What is the Purpose of a Swap?
When a trader keeps a leveraged position open overnight, interest must be paid on the borrowed amount. Swap charges are, therefore, the interest charged for leveraged funds.
-
When Are Forex Swaps Charged?
Swaps are charged only after opening a currency position until the next forex trading day. The exact moment a swap is applied to a trading position depends on the broker. But it's usually about 5 PM EST.
-
Why is the Forex Weekend Swap Different From Other Days?
A trader earns or is charged an overnight FX swap (interest rate) from/on their trading account if they hold a position overnight any day of the week. However, forex markets do not work on the weekends; therefore, the weekend swaps are credited on Wednesday. This is known as the Wednesday triple swap.
-
What if I Want to Trade Forex Without Swaps?
If a trader does not wish to receive or pay overnight swaps on their trade, they can trade on swap-free trading accounts. Swap-free accounts (also known as Islamic Forex accounts) do not generate swaps. Alternatively, they can close a position before the rollover point — no interest is charged or earned for day trading.
-
What Determines the Interest Rate Behind a Forex Swap?
The interest rate behind individual currencies depends on the decisions of their local central banks. Since each central bank has a different policy, interest rates vary as well. This difference determines whether the trader's account is credited or charged for the swap.
The amount earned or charged depends on:
- The time of opening the position
- The broker commission rates
- The difference in interest rate between the duo currencies
- Price movements of the currencies
-
What is a Negative Currency Swap?
A negative currency swap occurs when the currency bought has a lower interest rate than the leveraged currency position.
-
What is the FX Swap Cost?
A swap cost is an amount charged from a trading account when the interest rate of the sold currency is higher than the one of the bought currency. For example, if a trader buys EUR/JPY and JPY has a higher interest rate, they will be charged an additional swap forex fee if they hold the position open overnight.
-
How Do I Reduce Forex Swap?
Forex swaps are calculated depending on the interest rates of the individual currencies in the duo. Therefore, a trader can't reduce them independently. However, they can decide to avoid trades carried overnight — in which case no swap is charged — or trade on a swap-free account that does not attract swap charges.
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