Currency Swaps and FX Derivatives
Swap and derivative building blocks
An FX swap combines a near-date exchange and an opposite far-date exchange. It is used to roll settlement dates or manage short-term funding, not to create a long-term interest rate exposure. A cross-currency swap exchanges interest payments, and often principal, in two currencies over a longer term.
- FX swap: near leg at spot or a forward date, far leg at a later date; the swap points reflect the interest rate differential for the period.
- Cross-currency swap: exchanges floating or fixed interest in different currencies; used to hedge long-dated funding and asset exposures.
- FX options: a call gives the buyer the right to buy the base currency; a put gives the right to sell it. The buyer pays a premium.
- FX futures: exchange-traded, standardised contracts with daily margin and central clearing.
Worked example
A client buys a EUR call/USD put on EUR 1,000,000 with a strike of 1.1000 and pays a premium of USD 0.0100 per EUR, or USD 10,000. At expiry, spot is 1.1200. The call is exercised: payoff = (1.1200 − 1.1000) × 1,000,000 = USD 20,000. Net profit = 20,000 − 10,000 = USD 10,000. If spot were at or below 1.1000, the option expires worthless and the maximum loss is the USD 10,000 premium.
Traps
- Confusing an FX swap with a cross-currency swap; the former is usually short-dated and exchanges principal at two dates.
- Forgetting to deduct the option premium from the payoff.
- Mixing up calls and puts when the base currency is not USD.
- Ignoring margin, variation margin and clearing for futures.