Fx Swap and Forward Market
As we all know, our positions in the FX market are liable to either a credit or a debit at the end of each trading day. Known primarily as Carry, swap or rollover the charge made to the trading account is dependent on interest rates. Before we go further, we need to understand what an FX swap is, It is the buying/selling of a spot currency pair, while simultaneously selling/buying a forward contract of the currency pair of the same value.

The FX swap market is the biggest single market in the world, taking up about 40% of the FX markets, which is by far the largest in the world by asset class

To understand the idea here, we need to know about interest rate parity, while there is a pretty basic formula, the idea is as follows. If one country has a higher interest rate than the other country in the trade, then it is feasible to suggest that I could buy the higher yielding currency by selling the lower yield one and park it in risk free deposits and receive a return, this is the entire concept of the carry trade.

However, to prevent arbitrage, buying a currency pair in the future must discount this.

As we can see above, this is the forward curve for the AUDUSD, I looked at this due to the relatively high interest rate differential. As we can see in the bottom left corner, the interest rate differential is 2.45%. This can be seen by the difference between the spot price at just over 0.90 (when screencap was taken) and the 1Y forward rate being at 0.8792.

So when you buy the AUD at spot, you are required to settle this trade at T+2, that is 2 days after the trade you need to settle, or you can roll it over to a new contract as it were. Lets take an example, You are long the AUD at 0.9, and its coming to the end of the day, and you decide to hold it.

You look at the swap markets and see the overnight AUD forward trading at -0.6 pips. This means at the settlement time, you simultaneously sell you current AUD trade at 0.90, and buy the overnight AUDUSD at 0.89994 (0.90 subtract 0.6 pips). In essence you have just received 0.6 pips as your average cost in your long is now lower by 0.6 pips.

now considering once again the forward curve above, if you were to hold for one year, you'd receive approximately 0.6 pips per day for 1 year, therefore 0.6*365 = around 220 pips. This is the discount the AUD 1Y forward is to the spot price. Alternatively, you could buy AUD 1Y forward and each day, the position you have gets 0.6 pips closer to the spot price, so once again you receive the equivalent of 0.6 pips.

So below shows the pips you receive for holding it for certain periods.

The instant question is normally, why are the points negative? - well simply, think back to the curve earlier, when you are buying a currency with a higher yield, you are effectively buying it at a discount, hence the negative points quote.

This concept is pretty much the same in the Futures markets - Where we can see the same sort of principal apply.

Here we can see the German 10Y bond future forward curve for the next expiration, and while the picture is a little small, its just big enough to see the detail required.

So, the difference between what you buy/sell the front contract with the second contract is 0.42% (in left red circle). This is a quarterly contract, so if we multiply this by 4, we get around 1.68%, this is the annualized discount that the second Bund contract trades at. I have overlayed a 10Y German bond, and we can see it yields about 1.65% per year. So pretty much what the discount on the contracts sees.

So addressing points made on my webinars in more detail, when you are buying a forward futures contract, all you are doing is just capturing the yield you would have gotten if you owned the actual bond. There is no arbitrage opportunities available that are worth doing. All the price of the front month does is just mark lower by the respective discount and continue trading as normally.

One important thing about FX swaps, is that there is basically no FX risk in them, that is cancelled out by being long and short the same notional amount. The changes are due to interest rates, therefore it is entirely possible, if one can trade Forwards you can easily trade interest rates without having the need for futures.

This allows so much more to be done in the FX markets - for example, it is possible to trade relative value to the FX markets. Here is a popular chart I use in my webinars, it shows the 2Y EUR forward points in purple, and the EURUSD in red and green. With the difference between the lines in a histogram on the bottom pane.

As we can see, there is an incredibly strong correlation, and the trading strategy goes, when the EUR is far above swap (I.e. now) you Sell the EURUSD and receive forward points (that means you want forward points to decrease, as we can see the Left scale is inverted), and vice versa if the EUR is trading below swap level.

This has performed incredibly well over the past year (and frankly as long as my charts go back), with the only difficult part weighting the trade to replicate a profit/loss akin to the bottom pane. As we can see the tendency for that pain to revert back to 0, this trading strategy involving FX swaps is very useful.

As always, I welcome any questions.

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