Spot Risk in FX Swaps
- 02:43
Learn about how spot risk arises in FX swaps despite the cash flows being pre-determined.
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Glossary
Forward Mark to MarketTranscript
Let's take a look at the risk profile of FX swaps starting with spot risk. When it comes to outright FX forwards, their mark-to-market values can fluctuate significantly as FX spot rates change.
Imagine you've agreed to buy 100 million euros against US dollars on a six month forward basis locking in the rate for the exchange in six months time. Now, if the US dollar strengthens during that period, you could face a mark-to-market loss. Why? Because a stronger dollar would allow you to buy those 100 million euros for fewer dollars at the new spot rate, potentially making the forward agreement less favorable. Now, when we talk about FX swaps, they can be interpreted as collateralized borrowing and lending transactions where all cash flows are predetermined. This might lead you to believe that FX swaps carry no exposure to spot rate changes. While this is mostly true, there is still a small element of residual spot risk in FX swaps.
Here's why, as per market convention, one of the two currency amounts is typically kept constant. For example, an investor buys and sells 100 million US dollars versus euros, meaning they buy 100 million US dollars at spot and sell the same 100 million US dollars on a forward basis.
However, if you look at these two cash flows on a present value basis, they don't perfectly offset each other. This happens because assuming positive interest rates, the present value of the 100 million US dollars received at spot is exactly 100 million US dollars, but the present value of the 100 million US dollars paid in six months will be less than 100 million due to discounting. As a result, this creates a small net long position in US dollars on a present value basis basis. And naturally this implies a small, short position in the other currency, which in this case would be euros. While this residual spot risk is much smaller than the outright spot risk you'd face in an FX forward, it's important to be aware of it when using FX swaps.