Let's explore FX swaps, which play a significant role in daily average turnover within FX markets. And let's begin by defining what an FX swap is. A textbook definition of an FX swap is that it combines an FX spot trade and an FX forward trade. What that means is that in an FX swap, a counterparty agrees to buy a currency at the current spot rate and simultaneously agrees to sell the same amount of that currency at a future date using a forward rate.

The key point here is that both the spot price and the forward price are fixed at the start of the trade. So all cash flows are known from the beginning. There are a couple of terms worth mentioning here. The spot transaction, which happens immediately is called the near leg. The forward transaction, which happens later is called the far leg.

Let's go through a concrete example to illustrate how an FX swap works.

Suppose an investor enters into a six month euro US dollar FX swap to buy and sell 100 million US dollars. The current market to data shows a euro US dollar spot rate of 1.095 and six month forward points being plus 89.1. On the near leg, the investor buys 100 million US dollars against euros at the spot rate of 1.095. This results in the following cashflow at the start of the trade. The investor receives 100 million US dollars and pays 91,324,200.91 euros. On the far leg, the investor sells 100 million US dollars against euro six months after the spot date using the current six month forward rate, which incorporates the forward points.

Let's calculate this forward rate as understanding how forward points work is key to correctly pricing FX swaps. In the euro US dollar currency pair, one forward point is one 10000th of a dollar or $0.0001. To calculate the six month forward rate, we divide the forward points 89.1 by 10,000, which gives us 0.00891.

We then add this to the spot rate to get the forward rate. If the forward points were negative, we would subtract instead of adding. This gives us a forward rate of 1.095 plus 0.00891, which equals 1.10391. Consequently, the cash flows for the far leg are that the investor delivers 100 million US dollars and receives 90,587,094.96 euros, which is 100 million divided by 1.10391 at the six months forward rate. There are a few key things to note about FX swaps. First, one of the currency amounts usually stays the same. In this example, the US dollar amount of 100 million remained constant in both legs of the swap. Second, both legs are based on the same initial spot rate, but the forward legs price is adjusted by the relevant forward points. It is not based on an expectation of the spot FX rate six months into the future.

And third, all cash flows are locked in at the start of the trade, meaning that the investor is not exposed to changes in the FX spot rate over the life of the swap.

At this point, you might be wondering if FX swaps don't expose the investor to changes in FX rates, why would anyone use them? The answer is that FX swaps are primarily used for liquidity management and short term funding. Let's say a corporation needs temporary access to a foreign currency, they could use an FX swap to get the currency they need without taking on FX risk, knowing that they'll reverse the transaction later at a predetermined rate.