Foreign-Exchange Swap

A foreign-exchange swap exchanges two currencies immediately and reverses the exchange on a predetermined future date. Its opposite spot and forward legs temporarily change currency funding and domestic liquidity while fixing the exchange rate for the reversal.

Effect on rupee liquidity

In a dollar-rupee swap, the direction of the RBI's spot transaction determines the immediate liquidity effect; the forward leg broadly reverses that effect at maturity.

• In an RBI buy-sell swap, the RBI buys dollars spot and pays banks in rupees, thereby injecting domestic rupee liquidity. It sells the dollars back forward, and banks return rupees at maturity.
• In an RBI sell-buy swap, the RBI sells dollars spot and receives rupees, thereby absorbing domestic rupee liquidity. It repurchases the dollars forward and releases rupees at maturity.
• The precise rupee amount at reversal reflects the agreed forward rate, including the forward premium or discount.

Currency risk and balance-sheet effects

A predetermined reversal converts uncertainty about the future exchange rate on a matched exposure into a known forward rate. Currency risk is reallocated between counterparties rather than eliminated.

• A bank hedging a matching foreign-currency exposure reduces exchange-rate uncertainty on the principal, while the central bank acquires the opposite forward position.
• Gross spot reserves and the central bank's net forward position may move in opposite directions during the swap's tenure.
• Predetermined reversal limits exchange-rate risk on the exchanged principal, but counterparty, settlement and rollover risks remain.

Uses and limitations

Unlike an outright foreign-exchange purchase or sale, a swap creates a temporary liquidity effect. It can address short-term foreign-currency funding stress, smooth disorderly market pressure and preserve flexibility for outright intervention.

• Domestic liquidity effects may be offset through repos, reverse repos or other liquidity-management instruments.
• Reciprocal central-bank swap lines can provide another country's currency for onward supply to domestic institutions.
• A swap cannot correct insolvency or a persistent external imbalance; its scale is constrained by reserve adequacy, market conditions and balance-sheet considerations.