If you’ve been doing forex trading for a while, you may have come across the term “swap.” But what exactly is forex swap? In forex trading, a forex swap is an agreement between two parties to exchange currency for an agreed-upon amount of time. The swap agreement defines the currencies being exchanged as well as the amount of time the trade will last.
A forex swap can be used to hedge against currency risk or to speculate on changes in interest rates. For example, if you think that the U.S. dollar will strengthen against the Japanese yen, you could enter into a forex swap where you exchange dollars for yen. If your prediction comes true, you will profit from the trade.
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There are two types of forex swaps:
- Spot forex swap: A spot forex swap is an agreement to buy or sell a currency pair at the current spot rate. The trade is settled immediately, and the agreed-upon amount is exchanged on the spot.
- Forward forex swap: A forward forex swap is an agreement to buy or sell a currency pair at a future date, at an agreed-upon exchange rate. The trade is not settled immediately, but rather at the specified future date.
Forex swaps are usually done for periods of one week to one year but can be longer.
When you enter into a forex swap, you are essentially borrowing one currency and lending another. For example, in a USD/JPY forex swap, you would be borrowing U.S. dollars and lending Japanese yen.
The interest rate differential between the two currencies will determine whether you pay or receive interest on the swap. If the interest rate on the currency you are borrowing is higher than that on the currency you are lending, you will earn interest on the swap.
Conversely, if the interest rate on the currency you are borrowing is lower than the interest rate on the currency you are lending, then you will pay interest on the swap.
Most forex brokers will automatically roll over forex swaps at 5 PM EST each day so that positions are held overnight. However, some brokers may charge a small fee for this service.
How to Calculate Forex Swap Rates?
Forex swap rates are typically calculated using the overnight interbank interest rate for the currency pair.
To calculate a forex swap rate, the overnight interbank interest rate for the currency you are buying is subtracted from the overnight interbank interest rate for the currency you are selling.
For example, if you are long USD/JPY and the overnight interbank interest rate for USD is 0.50% and the overnight interbank interest rate for JPY is 0.25%, then your forex broker will charge you a forex swap rate of 0.25%.
If you were short USD/JPY, then your broker would pay you a forex swap rate of 0.25%.
Conclusion:
Overall, forex swaps can be both a rewarding and risky trading strategy. Swaps can be used to speculate on changes in currency rates, or to hedge against currency risk. It is essential to understand how forex swaps work before entering into any trades.
