Foreign Exchange Swaps
Bartolini, Leonardo, New England Economic Review
Foreign exchange swaps have appeared for some time in the intervention toolkit of many central banks around the world, although their popularity seems to be on the wane. In a Bank for International Settlements survey taken in 1997 (BIS 1997, p. 332), seven of fourteen industrial-country central banks surveyed listed foreign exchange swaps against either the U.S. dollar or the deutsche mark (or both) among the tools used to conduct open market intervention. Of those seven, five--Austria, Belgium, Germany, Italy, and the Netherlands--discontinued foreign exchange operations when they became part of the European Monetary Union. Of the remaining two, Australia and Switzerland, only the latter has used foreign exchange swaps extensively, at some point as its main intervention tool, with the total amount of swaps hovering for years at about 40 percent of the monetary base. This use partly reflected the limited depth of domestic debt markets associated with limited fiscal deficits historically incurred by the Swiss government.
Formally, a foreign exchange (FX) swap is a financial transaction whereby two parties exchange agreed-upon amounts of two currencies as a spot transaction, simultaneously agreeing to unwind the exchange at a future date, based on a rule that reflects both interest and principal payments. When the initiating agent is a central bank, the motivation for undertaking the swap is usually either to affect domestic liquidity or to manage foreign exchange reserves. (Rarely, central banks have been known to use currency swaps for the main purpose of hedging and assetliability management.)
As described above, intervention through FX swaps can be thought of as a repurchase agreement (repo) with foreign currency as the underlying collateral instead of securities. When the forward leg of the operation is missing, the transaction becomes formally similar to an outright open market operation with foreign exchange as the underlying asset, and the operation is usually classified as FX "intervention," rather than a swap. In parallel fashion, a distinction is often made with respect to the scope of the operation: While FX swaps are usually seen as aimed at controlling domestic liquidity FX intervention is usually seen as aimed at influencing the exchange rate.
By virtue of combining a spot and a forward transaction, FX swaps can also be priced easily, based on available forward quotations and, generally, satisfying the covered interest parity condition. Viewing swaps essentially as forward transactions also highlights requirements for their effective use--namely, price stability depth of the underlying forward market, and ready availability of quotes--requirements that have led most central banks active in the swap market to undertake operations mostly in U. …