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I am familiar with FX swap and the basis/IR risk they carry. However, know that they have a very small spot risk component which arises from the present value of future cash flows different from the value of cash flows today.

Can someone please provide an intuitive explanation of where this spot risk actually arises ?

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I have only traded a few FX swaps and not in a while so do correct me if my understanding of their technical product specification is not correct:

A Purchase of an FX Swap with say, a 3M tenor, at an initially struck spot rate and forward rate demands the spot receipt of a nominal amount of domestic currency and the payment of rate equivalent foreign currency. At the end of the 3M tenor the same domestic notional amount is paid back and the foreign currency is received adjusted by the forward rate.

The key to your question, I believe, is the fact that the same domestic notional is received back after 3months, when under traditional (no arbitrage) scenarios that amount would have grown by an amount equivalent to the (cross-currency adjusted) rate of interest.

Suppose for EURUSD; spot: 2.0000, 3m fwd: 2.0100, FXFWD: +100 pips.
Suppose EUR interest rate is 4% p/a and in USD it is 6.04% p/a.
Suppose you purchase EUR1000 EURUSD FX swap at 100pips struck at 2.000

Your cashflows look like this from the FX swap:

Date     EUR     USD
Today    1000    -2000
3m fwd  -1000    +2010.1

But don't forget about the interest over 3M:

Intst      10      -30.2
Total      10      -20.1

If the FX rate at the end of the period is 2.01 as predicted then 10 eur == 20.1 usd so you have zero PnL, but if it deviates you have either a small loss or a small gain.

It is this component that you have FX exposure to. The smaller interest rates are the smaller this discrepancy so the risk is reduced.

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  • $\begingroup$ As you can see, if you wanted to protect yourself from this small FX exposure you would have to, in addition to the purchase of 1000 EUR in an FX Swap, also enter into a sale of 10 EUR (= the interest you will earn on EUR) for the same date via a outright forward sale (at the same forward rate). Then you would have no FX exposure. $\endgroup$ – Alex C Mar 15 at 19:02
  • $\begingroup$ Thank you for taking the time to explain this! Very useful. I think I understand the intuition now, the spot position can therefore be summarised as the net PV of all the cashflows in the swap. I.e 10 eur in this scenario $\endgroup$ – bjmcgeough Mar 16 at 10:55

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