FX Swap

An FX swap is two trades stapled together: exchange currencies today (the "near leg", usually at spot), and re-exchange them back at a fixed future date (the "far leg", at the forward rate). You end where you started — but for the period in between, you held the other currency.

That makes an FX swap really a collateralised loan: a European bank swapping euros for dollars for three months has effectively borrowed dollars, pledging euros. No credit line needed beyond the swap itself — the currencies collateralise each other.

This is quietly the biggest instrument in the biggest market: FX swaps account for over half of all FX turnover, because the entire global banking system uses them daily to fund currency mismatches and roll hedges.

Mechanics and quoting

• Quote: swap points — the gap between far and near rates (the forward points for that tenor).
• Tenors: overnight ("tom-next" rolls are the daily heartbeat of position management) out to a year-plus.
• Uses: rolling forward hedges (close old, open new in one trade), funding foreign-currency assets, cash management across currencies.

The dollar funding story

Non-US banks hold trillions in dollar assets but lack dollar deposits — FX swaps bridge the gap. In stress (2008, March 2020), everyone wants dollars at once: swap points blow out, the implied dollar borrowing cost spikes far above US money rates, and the Fed opens swap lines to foreign central banks — lending dollars through exactly this instrument to calm it.

Hidden leverage debate

Because FX swap obligations sit off balance sheet, the BIS calls the resulting ~$80tn+ of "missing" dollar debt a blind spot in global statistics — a recurring financial-stability theme.

Implied yields and the basis

From swap points, back out the implied funding rate of one currency in terms of the other:

The residual \(b\) is the cross-currency basis — the premium for dollar balance sheet. Drivers: regulatory balance-sheet costs (leverage ratio makes matched-book FX swap intermediation expensive), hedging-demand imbalances (Japanese/European institutional dollar-asset hedging), quarter-end window dressing, and counterparty tiering.

Term structure of the basis

Short tenors spike on turns (year-end prints of −100bp+ have occurred in EUR and JPY); longer tenors trade via cross-currency swaps. Basis curves are now a distinct asset class with dedicated RV desks; the persistent CIP violation is the textbook example of post-crisis limits to arbitrage.

Central-bank swap lines as a ceiling

Fed lines lend dollars at OIS+25bp against foreign-currency collateral: an effective cap on the basis in crises — observed as basis compression exactly to the line's cost when usage surges. Pricing dollar funding without checking line terms is incomplete in stress regimes.

Settlement and PVP

Both legs carry Herstatt-style settlement risk if not PVP; CLS covers major pairs, but growth in non-CLS EM swap turnover keeps settlement risk on the BIS worry list.