Assume we have an exporter who is looking to hedge their USD exposure. How would they decide between choosing a FX swap or a FX forward contract to do so? I understand that a swap has 2 exchanges, while a forward is just 1 at settlement date. But would like to understand why one would be chosen over the other. Thanks!
An FX swap exposes the user to a risk that is intrinsic to the interest rate differentials and supply and demand factors of one currency relative to another, but fundamentally there is negligible exposure to the spot FX rate, since one essentially agrees to a buy price and a sell price separated by a fixed amount.
A forward FX contract is an agreement to exchange FX at a specific rate. This exposes the user to the risk that spot FX rates move (since spot FX is the dominant driver of forward FX rates), and one has essentially only agreed to a buy price, whereas the sell price is left to chance of the FX market. The forward part (i.e. settlement) is usually only a consideration based on whether you want (or need) to settle at some future point, and will have the currency available.
For example, say if one is an exporter based in EUR, who sells products in USD, and therefore regularly receives future cashflows in USD, then one has genuine risk to the EURUSD FX spot rate. The best hedge is to transact a forward FX converting USD to EUR at prior agreed (and therefore known) values based on the future profile of expected cash receipts.
Assuming you are a US based exporter, exporting to a foreign country and will be paid in their local currency at some future point in time for the goods you ship today, you would initiate a forward position to initiate the hedge. Say it is 1MM EUR that your customer agrees to pay you for the goods in 1 month after you ship the goods. You are now long 1MM 1month EUR by entering into this agreement with your customer. You would initiate the hedge by selling 1MM EUR/buying USD 1 month forward to lock in the USD price of the EUR you will receive in 1 months time.
An FX Swap would be used if you are rolling your hedge. For example above, if you and your customer subsequently agrees that they will now pay you the 1MM EUR in 2 months time, you would now need to roll your hedge. In this case an FX Swap would be ideal. You would buy back the initial 1MM EUR you sold at the initiation of your hedge and sell 1MM EUR, buy USD at the 2MM date. Since you are buying and selling the EUR on the fx swap, you (and the dealer) are not exposed to spot but only to the forward points. The swap may be a forward swap depending on when you change your agreement with your customer.