A currency swap, or swap, is a foreign exchange transaction in which two parties agree to exchange one currency for another at a future date. The currencies are then exchanged immediately at an exchange rate adjusted to reflect the expected rate of the future date, known as a forward exchange rate.
Swaps are commonly used to hedge long-term investments involving a foreign currency. They’re often initiated between companies doing business abroad when one company is paid significantly later than when the service or product is delivered.
How to calculate the forward exchange rate?
The forward exchange rate is calculated by multiplying the current exchange rate, known as the spot rate, by the ratio of the two currencies’ interest rates. The formula is:
Forward exchange rate = spot rate x ((1 + domestic interest rate)/(1 + foreign interest rate))
This figure is then adjusted for the length of the swap. Most currency swaps occur in 30 days, 90 days, or 180 days.
Forward exchange rates are often calculated with confirmation from an intermediary such as a bank or other financial institution.