A currency swap is the simultaneous purchase and sale of foreign exchange for two different dates. Currency swaps are an increasingly important component of the foreign exchange market. Suppose a Swedish carmaker imports parts from a subsidiary in Turkey. The Swedish company must pay the Turkish subsidiary in Turkish lira for the parts when they are delivered tomorrow. It also expects to receive Turkish liras for cars sold in Turkey in 90 days. Our Swedish company exchanges kronor for lira in the spot market today to pay its subsidiary. At the same time, it agrees to a forward contract to sell Turkish lira (and buy Swedish kronor) in 90 days at the quoted 90-day forward rate for lira. In this way, the Swedish company uses a swap both to reduce its exchange-rate risk and to lock in the future exchange rate. In this sense, we can think of a currency swap as a more complex forward contract.
Simultaneous purchase and sale of foreign exchange for two different dates.
Recall that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. In contrast, a currency option is a right, or option, to exchange a specific amount of a currency on a specific date at a specific rate. In other words, whereas forward contracts require parties to follow through on currency exchanges, currency options do not.
Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate.
Suppose a company buys an option to purchase Swiss francs at SF 1.02/$ in 30 days. If, at the end of the 30 days, the exchange rate is SF 1.05/$, the company would not exercise its currency option. Why? It could get SF 0.03 more for every dollar by exchanging at the spot rate in the currency market rather than at the stated rate of the option. Companies often use currency options to hedge against exchange-rate risk or to obtain foreign currency.
Currency Futures Contracts
Similar to a currency forward contract is a currency futures contract—a contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.
currency futures contract
Contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable