FX Products - Vanilla (II)

4. Forex Swaps
This is an agreement to buy/sell a ccy at an agreed rate, with an agreement to sell/buy back the same amt of currency also at an agreed rate at some future date.
Essentially, Forex Swap =  Spot+ Offsetting Forward Transaction. Thus this is similar to a long/short position + short/long hedge. Delta risk is minimal due to offsetting impact. Main risk is interest rate or basis risk. Basis risk = Spot price - Forward price. For short hedger, he stands to benefit from a strengthening of the basis.
Forex swap are mainly used for ST funding purpose or by financial instituitions to rollover fx balances where swap points represent the funding cost. Eg. Company A has SGD in her account but requires USD100k to fund an overseas project for the next 3mths. However, it does not want to assume any fx risk. Solution: (1) Sell SGD Buy USD100k at spot rate 1.21. (2) Buy SGD Sell USD100k at spot rate 1.2 after 3month. The 1000SGD difference represent the interest rate differential between USD vs SGD (usd i/r higher than sgd i/r).

5. Currency Swaps.  This is an agreement in which both counteparties agree to swap cashflow in one currency to another currency based on 2 different interest rates on a periodic basis, with the agreement to swap back to the original currencies principals on maturity. Technically the trade can be viewed as 2 bonds- buy/sell in lcy bond and sell/buy in foreign bonds.  Currencies swaps are used for LT funding purpose and can lower borrowing costs for the firm; it is also used to restructure assets/liabilities in the balance sheet where asset/liabilty in one ccy can be converted to another currency either based on fix/float basis. Eg. A EUR firm in US wishes to borrow in EUR but has to issue USD bonds. Solution: It enters into a EUR/USD swap in which it agrees to pay EUR float while receiving USD fix. At inception, it swaps USD for EUR with an agreement to swap EUR back to USD at maturity. Thus spot risk for the principal is hedged. On interest settlement dates, USD receipts from the swap are used to offset USD coupon payments. The net impact is thus EUR payments. So effectively, its funding is in EUR.