What Is A Forex Swap?

What is forex swap? Many new traders get confused with forex swap. In simple terms, forex swap is the simultaneous buying and selling of the same amount of currency but at two different dates. Let’s make it clear what is a forex swap. Suppose you want to go long on EUR/USD pair. Going long means buying EUR and selling USD. Now when you trade with a broker you are trading on margin. Trading on margin means that you can control a large sum with a smaller sum. Most brokers will allow you to trade a standard lot of 100,000 units with a small deposit of $1,000.

So when you will trade EUR/USD pair on margin, you are going to borrow $100,000 in order to buy EUR. If you keep this long position open for a few days, you will have to pay an interest on the loan borrowed from the broker. But since you are holding EUR as well, you will get an interest payment on that amount as well. So what you will get is the net interest payment depending on what was the differential between the interest paid and the interest earned. This differential will be shown in the swap column.

Now this was a simple explanation for you. But in reality what happens practically at the broker end is that each currency transaction has two parts. In the first part which is the spot transaction, you buy and sell the currencies at the agreed upon date at an initial date. This is the near date. In the second part which is the forward transaction, the same amount of currencies are bought and sold at an agreed upon rate on another date that is known as the far date. So what has practically happened that the spot market risk that you were exposed to with the first transaction is essentially hedged with the second transaction at the far date. So the net exposure is zero or almost zero. The relationship between the spot and the forward rate is known as the Interest Rate Parity. For practical purposes, the difference between the forward and the spot rates is roughly equal to the interest rate differential between the two currencies that you are trading.

The days between the near date and the far date involves a cost of carry as explained above. This cost of carry is known as the rollover or the swap and is shown in the swap column of each trade that you make. You might be wondering what is the need to make two simultaneous currency transactions. The purpose is to avoid any delay in the delivery required on the contract. Remember, each currency transaction is a contract. So inessence, a forex swap is a agreement between two parties (you and your broker) to exchange the same amount of one currency for the another currency  and after a certain date give back the original amounts that were swapped. Forex Swap is done due to margin trading that you are allowed to do with the broker and entails the payment of interest as explained above. You need to keep this in mind that a forex swap is a different thing as compared to a currency swap.

 

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