Banks find it essential to accommodate their client’s requirements to buy or sell foreign exchange forward, in many examples for hedging purposes. How can the bank eliminate the currency exposure it has made for itself by accommodating a client’s forward transaction?
Answer: Swap transactions offer a means for the bank to mitigate the currency exposure in a forward trade. A term swap transaction is the simultaneous sale or purchase of spot foreign exchange in opposition to a forward purchase (or sale) of an almost equal amount of the foreign currency. To demonstrate, suppose a bank customer wishes to buy dollars three months forward against British pound sterling. The bank can handle this type of trade for its customer and concurrently neutralize the exchange rate risk in the trade through selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months till they are required to deliver against the dollars it has sold forward. The British pounds received will be employed to liquidate the sterling loan.