Swaps

A swap transaction (not to be confused with the swap rate) is a double-leg deal, in which one buys spot currency X selling currency Y and simultaneously sells forward currency X buying currency Y. Let us give an example to show the rational of such a transaction. Assume that an American investor has a future receipt in Dmarks. In addition, assume that he thinks that German bonds are presently a good investment. So he has dollar assets but does not hold cash in marks. In plain words he needs marks right now and cannot wait for the future receipt marks to come. One solution would be to sell dollars and buy marks in the spot market. However, suppose he does not wish in a foreign exchange adventure for he cannot forecast the exchange value of the future receipt. In this case he sells dollars against marks spot getting his marks and buying his bonds. Simultaneously he buys dollars forward against marks matching the value date of the receipt. Upon expiration of the forward period, the investor cashes the receipt, pays back the marks that he owes and gets his original dollars. Hence he has been able to overcome the time lag problem.