Foreign Exchange Swaps
Use of Foreign Exchange Swaps by Central Banks
A foreign exchange swap is a financial transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay at a future date according to a predetermined rule reflecting both interest payments and amortization of the principal (Bank for International Settlements Opens in new window, 1986, p. 37).
In the 1980s, different types of foreign exchange swaps (and other kinds of swaps, such as interest rate swaps and debt-equity swaps) became quite fashionable and received much attention in the press and in the economic literature. Most of these publications focused on the fast-growing interbank swap market. Less publicized, however, is that for several decades central banks have also used foreign exchange swaps.
The dominant objectives of the central banks in using foreign exchange swaps are to affect domestic liquidity, manage their foreign exchange reserves, and stimulate domestic financial markets.
Definition and Pricing
In the 1980s, a common foreign exchange swap involved the exchange of streams of payments over time; that is, streams of interest payments are exchanged for the period between the initial and maturity dates. (For clarity, we call this more sophisticated type of swap a “currency swap,” even though this distinction is not always made.)
For a much longer time, however, a simpler type of foreign exchange swap transaction has been used in foreign exchange markets: only the principal amounts are exchanged on the initial and maturity dates at predetermined exchange rates.
For example, one party sells U.S. dollars spot against deutsche mark and simultaneously buys U.S. dollars forward against deutsche mark from the same counterparty. This latter kind of swap is the most relevant here, because central banks tend to use it much more often than currency swaps.
According to the covered interest parity condition, the forward premium, or discount, reflects the corresponding differential between interest rates on the international markets.
Thus, if S, the spot price of foreign currency (deutsche mark) in terms of domestic currency (U.S. dollars) equals 0.5, and if R (the domestic nominal interest rate) equals 12 percent a year and R* (the German nominal interest rate) equals 10 percent a year, our party in possession of a domestic asset worth US$100 can do one of two things:
- keep the domestic asset and sell it after a year, receiving (1 + R ) 100 = US$112;
- or sell it for US$100, buy (1/S )100 = DM 200, invest this in a German asset for a year, and sell the proceeds forward, at the forward exchange rate F. He would receive F/ S(1 + R*) 100 = F (DM 220).
Risk-free arbitrage should ensure that both strategies have the same return, that is, that no unexploited profit opportunities exist, so that US$112 = F (DM 220), or F = 112/220 = 0.5091.
The deutsche mark is at a forward premium to compensate for the lower German interest rate. In general
F = S (1 + R )/(1 + R*).
If we define the forward premium as ƒ = (F – S) / S = F/S – 1, then
1 + ƒ = (1 + R*) ↔
1 + R = (1 + R*) (1 + ƒ ) = 1 + ƒ + R* + ƒR* ↔
R – R* = ƒ (strictly, ƒ + Fr*, with ƒR* negligibly small).
In our example, ƒ is approximately 2 percent, which is also the interest rate differential. This forward premium, sometimes called swap premium or swap rate, is what we consider the price of the instrument. In countries with well-developed forward exchange markets, this price is market determined, and quotes can be obtained from commercial banks.
Covered interest parity should hold under perfect capital mobility if the assets considered are comparable in all aspects, such as default and political, or sovereign, risk, maturity, and tax treatment.
Several studies have shown that covered interest differentials among Eurocurrency deposits, which are identical in terms of political risk, are essentially zero. Of course, allowance must be made for transactions costs.
Four types of transactions costs arise with a covered outflow such as in our example:
- selling a domestic security,
- purchasing spot foreign exchange,
- obtaining a forward cover, and
- buying a foreign security all give rise to transactions costs.
These costs give an upper and a lower band within which deviations from covered interest parity do not conflict with efficiency. Higher deviations may be due to sovereign risk, but also to less-than-perfect capital mobility (i.e., time lags or less than infinitely elastic arbitrage schedules) (MacDonald and Taylor, 1989, p. 258 – 59).
Currency swaps (and also interest rate swaps and cross-currency interest rate swaps) are used by a wide variety of participants, for example, banks, corporations, thrift institutions, insurance companies, international agencies (the World Bank was a major driving force in the development of the market), and foreign states.There are four broad reasons to use swaps:
- to exploit differences in credit rating and differential access to markets, thereby obtaining low-cost financing or high-yield assets;
- to hedge interest rate or currency exposure;
- to manage short-term assets and liabilities; and
- to speculate.
Central banks have been known to use currency swaps for hedging and asset-liability management, but very rarely (or seldom publicized). For this reason, the technicalities of those operations will not be elaborated upon; a good discussion can be found in Smith, Smithson, and Wilford (1990).
Central Bank Swaps in the Balance Sheet
When a central bank carries out a foreign exchange swap, it has significant economic effects. Assume, for example, that the U.S. Federal Reserve System Opens in new window buys foreign exchange with domestic currency and simultaneously “sells it back” forward, that is, agrees to sell the same amount of foreign currency at a certain date more than two days in the future at the forward exchange rate.
As the Federal Reserve’s foreign assets increase, some item on the liabilities side must, therefore, increase, depending on the counterparty. If the latter is another country’s central bank, this institution’s account at the Federal Reserve is credited, meaning that the Federal Reserve issues dollars and the other central bank issues its own currency.
As long as both central banks do not spend their foreign currency, however, there is no effect on currency in circulation or on banks’ reserves, and both money supplies remain constant.
If the counterparty is the banking system, banks’ reserves are credited with the domestic currency equivalent of the foreign exchange purchase, and banks’ foreign assets decline.
Thus, reserve money increases, which normally causes an expansion of the money supply. (If the Federal Reserve had done a reverse swap—i.e., sold foreign exchange spot to domestic banks and bought it back forward—reserve money would have decreased, tightening the money market.).Another possible approach is to treat such swap operations as collateralized loans.
In analytic terms, expansionary foreign exchange swaps with deposit money banks are similar in form to direct loans by the central banks (as are discounting and rediscounting and repurchase agreements).
Depending on a complex of legal, historical, and institutional considerations, negotiable financial instruments may continue to be registered as assets in the balance sheet of the deposit money banks; their reserves item would increase and be balanced on the liability side by “central bank discounts received” (International Monetary Fund, 1984, p. 53). In this case, the central bank’s balance sheet does not show an increase in foreign assets but in domestic assets (claims on deposit money banks).
When the swap is unwound, both domestic assets and banks’ reserves return to their old levels, twith an interest payment going into the central bank’s profit and loss account. This is the same amount as the interest earned on the foreign asset, adjusted for the difference between the spot and forward exchange rates.
Another consequence of the expansionary swap (if the foreign currency is not considered as collateral, but as the actual property of the Federal Reserve) is the creation of a forward foreign liability for the Federal Reserve, matched by a forward domestic asset.
This matched pair of contingent accounts can be booked on or off the balance sheet, depending on local practice. For instance, Turkey uses such a four-entity system (i.e., with both the current and the forward items on the balance sheet), but it is far more common to record only a change in gross foreign assets plus a change in banks’ reserves.
A disadvantage of the four-entry system is that it inflates and complicates the balance sheet, but it has the benefit of showing clearly what part of the foreign reserves is only temporary, and, therefore, what exchange risk the central bank would be running if it lost its cover.
The swap in our example may not be intended as a money market tool; nonetheless, it still has the (temporary) expansionary effect on reserve money discussed above.
Thus, if the swap were undertaken to gain foreign exchange or to provide banks with a forward cover, the monetary expansion it would cause along the way would have to be sterilized (assuming the country did not incidentally also need a monetary expansion at the same time).
This means the Federal Reserve would have to sell some securities, for instance, bonds from a stabilization fund. The point is that the different goals for which central banks use foreign exchange often conflict.A last topic that needs to be discussed is the risk for the central bank involved with foreign exchange swaps.
When foreign exchange swaps are seen as collateralized loans, normally little risk is involved. The central bank need not worry about default risk because it has the collateral. Also, it is not exposed to exchange rate risk as long as it has the foreign assets to cover the forward foreign liability (neither of these need be shown on the balance sheet).
There is exchange risk as soon as either the asset or the liability disappears—that is, if the counterparty defaults before the swap matures (the central bank would suffer a loss if its domestic currency appreciated), or if the central bank runs out of foreign exchange reserves, that is, when the country has balance of payments (the central bank would suffer a loss if the domestic currency depreciated).
The latter situation has indeed occurred in many countries. Finally, there is a settlement risk involved with swaps, as is always the case in any foreign exchange operation—the so-called Herstatt risk. Although this risk is very small, it exists.