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Patient0
Topic Author
Posts: 8
Joined: October 30th, 2006, 10:29 am

### Exact mechanics of an FX Swap

I am trying to understand the exact mechanics of an FX swap transaction.Particularly, what determines the size of the notional of the forward transaction at the end?An example might illustrate my question better:AUDUSD Spot = 1.0690FxSwap forward points = -212.06Therefore: AUDUSD Forward = Spot + forwardPoints/10000 = 1.047794Suppose I have come into 1 million AUD that I'm not going to need for 1 yearand would like to receive the AUD yield implied from the swap rate(because my AUD bank account pays crappy interest, for example).So I enter into an FX swap. Today:I execute a spot trade to sell 1 million AUD for 1/1.0690 USD = 935453.70 USD.My 1 million AUD serves as collateral for my end of the bargain, and the 935453.70 USDserves as collateral for the counterparty's side of the bargain.SpotDate (T+2 business days):1 million AUD leaves my crappy AUD account and goes into the counterparty account.935453.70 USD goes into my US dollar bank account.For 1 year, my US dollar account that started with a balance of 935453.70 accrues interest at some rate.Question 1: Do I agree on a US dollar interest rate with my counterparty (i.e. interest that I will pay on their collateral?)Swap Expiry Date:My swap turns into a spot trade to exchange US dollars for AUD at a rate of1.0447794... but what's the notional?Ideally, I'd want it to exactly match whatever my 935453.70 US dollar balance hasturned into... I "pay interest" on the counterparty's US dollar collateral in US dollars and they pay meinterest on my "AUD" collateral in AUD.How is this "forward" notional agreed?
Last edited by Patient0 on February 22nd, 2012, 11:00 pm, edited 1 time in total.

rmax
Posts: 6080
Joined: December 8th, 2005, 9:31 am

### Exact mechanics of an FX Swap

An FX Swap is what you have described. The forward points (i.e. the price) result in the fact that you are depositing cash on the transaction and then swapping it at the end. So if you: Borrow AUD at a rate for 1 yearSpot AUD to USDDepostit USD in a bank account that accrues interest for 1 yearSpot USD back to AUD at the endThat should equal the forward points on the FX Swap. If it doesn't then there is an opportunity to arbitrage the position.

Patient0
Topic Author
Posts: 8
Joined: October 30th, 2006, 10:29 am

### Exact mechanics of an FX Swap

Thanks RMax,I know that this is how it is *supposed* to work, especially in theory, but I am in a debate with a trader about how it actually works in practise, particularly when it applies to using FXSwaps to hedge other derivatives - so I have to understand the specifics.What's the answer to Question 1? What would be a suitable forward notional?I guess what would probably help me the most would be if someone could point me to an example of a real-life FX Swap confirmation, so I could see what precisely is agreed between the two counterparties (and hence what is left implied by arbitrage considerations).

Patient0
Topic Author
Posts: 8
Joined: October 30th, 2006, 10:29 am

### Exact mechanics of an FX Swap

I found this to be exceptionally helpful Also, this document on page 29 appears to talk about the issue I was talking about.i.e. if you "fix" one leg or the other (e.g. fix to both lend and receive AUD notional) then you end up with a residual FX exposure. (e.g. in the St George document you end up with USD interest that you probably don't have much use for).To make it a perfect hedge for both counterparties, the spot and forward notional amounts have to be "unmatched", otherwise each side ends up with unwanted interest in a currency they don't actually care about.Finally, Section 1.2 of Castagna - Volatility and Smile Risk talks about "par" vs non-par FX swaps. For the non-par case, "the domestic rate must be agreed" which is as I understood it also.
Last edited by Patient0 on February 29th, 2012, 11:00 pm, edited 1 time in total.

rickyvic
Posts: 22
Joined: February 25th, 2011, 4:56 pm

### Exact mechanics of an FX Swap

I found the fx exposure to be very small, for my purposes, buy side, not worth making an unmatched swap, not sure if it is liquid too.

WallStreet85
Posts: 1
Joined: April 8th, 2012, 2:22 am

### Exact mechanics of an FX Swap

cosmologist
Posts: 640
Joined: January 24th, 2005, 8:08 am

### Exact mechanics of an FX Swap

May be if one of you come back here: I have a question which might look trivial but I need a discussion. FX Swap valuation is often stated as NPV of Near leg + NPV of Far Leg. This is ,I guess, to take into account the forward-forward swaps. My question is in the case of a six month swap when 4 months have already expired how do we MTM the swap? The simplest way is Notional * the difference of the current swap point and the traded swap point.1.I was asked by someone to explain him in form of the Near Leg and Far leg method. Any quick suggestion is most welcome.If we reverse the B/S (USD/XXX)swap, we do a S/B (USD/XXX) swap to square off the position. This naturally gives rise to a Spot sell of USD and Buy USD forward 2 months. The spot rate come into play. Am I missing out something here.2.Moreover, let us assume that the swaps are done with different counter-parties. Credit risk does come into play or not. Is it as straight-forward to price both the swaps without any consideration of the strength of the counter-parties.

DominicConnor
Posts: 11684
Joined: July 14th, 2002, 3:00 am

### Exact mechanics of an FX Swap

I found the fx exposure to be very small, for my purposes, buy side, not worth making an unmatched swap, not sure if it is liquid too.Do your risk people have the same view ?

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