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I know that FX Swaps have FX Risk, but why do FX Swaps have Interest Rate Risk as well?

Need some guidance on this.

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An FX Swap can be described as "borrowing in one currency and lending in another". When put this way it is clear that it has something to do with interest rates in the two currencies. You will be very happy if the i.r. in the currency borrowed rises and the i.r. in the currency lent falls the day after you do the deal, because you will have locked in more favorable rates for the term of the swap. So in that sense it is a bet on rates (more specifically on the difference in rates).

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    $\begingroup$ In similar manner, FX Forward has Interest rate risk as well right? $\endgroup$ – lakesh Aug 16 '16 at 2:21
  • $\begingroup$ The point of FX forward is to lock in the price today for a delivery in the future. So there is, sort of, i.r. risk because perhaps if you didn't take the forward today, then in 3 months the rates would be different (including the spot component). The forward isn't really about that though, it's about certainty of future cash flows. $\endgroup$ – rupweb Nov 30 '16 at 14:22
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Looking at the swap as a series of forwards, considering then that the arbitrage-free FX forward depends (via the so called interest rate parity) both on the FX spot and the interest rates for the terms and currencies involved; gives that both spot FX and IR spread impacts the FX swap.

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You can structure an FX swap in terms of money market deposits and loans and vice versa. Say you've got AUDSEK 1 year. The AUDSEK FX swap cash flows have to equal the cash flows you'd get on AUD deposits or loans versus SEK deposits or loans, depending on which way round you buy or sell the swap. Otherwise there's interest arbitrage between the FX markets and the money markets. The interest on deposits or loans in different currencies is all about the rate you will give for a deposit or take for a loan in the given currency for the 1 year, priced according to the competition between providers in the money markets. Go figure. Also check out http://www.webstersystems.co.uk/fxmm.htm#interest%20arbitrage

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