Foreign-Exchange Swap

A foreign-exchange swap is an agreement to exchange two currencies now and reverse the exchange on a predetermined future date. A central bank uses its opposite spot and forward legs to provide or absorb foreign currency temporarily, while producing an offsetting effect on domestic-currency liquidity.

How foreign-currency liquidity is injected

To ease a temporary shortage of foreign currency, the central bank conducts a sell-buy swap: it sells foreign currency to banks in the spot market and simultaneously agrees to repurchase the same currency forward.

• Banks receive foreign currency immediately for meeting external payments or funding needs, but must return it at maturity.
• The spot leg absorbs domestic currency, while the forward leg reverses both currency flows on the agreed date.
• The forward premium or discount, together with relevant interest rates, determines the implied cost of obtaining foreign currency.

How liquidity is absorbed

When foreign currency is abundant, the central bank may undertake a buy-sell swap: it buys foreign currency spot and commits to sell it back forward. This temporarily absorbs foreign currency from banks while injecting domestic currency.

• Because reversal is predetermined, a swap is temporary, unlike an outright purchase or sale of foreign exchange.
• Gross spot reserves and the central bank's net forward position may move in opposite directions during the swap's tenure.
• Domestic liquidity effects can be offset through repos, reverse repos or other liquidity-management instruments if required.

Uses and limitations

Swaps can smooth short-term funding stress, reduce disorderly pressure in the foreign-exchange market and conserve the flexibility of outright intervention. Reciprocal central-bank swap lines can also provide access to another country's currency for onward supply to domestic institutions.

• A swap addresses temporary liquidity mismatches; it cannot correct insolvency or a persistent external imbalance.
• Predetermined reversal limits exchange-rate risk on the exchanged principal, but counterparty, settlement and rollover risks remain.
• Its scale is constrained by reserve adequacy, market conditions and the central bank's balance-sheet considerations.