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Given a currency pair and two future dates, I have to exchange the same amount of money but with different directions on these dates (example: my company works in € and I have to pay 1000\$ in one year and I'll get 1000\$ in two years, which I'll exchange to € again). I want to minimise risk and costs.

I see two options:

  • Option 1: I can get one forward for each transaction.
  • Option 2: While I have two open positions in different directions, the fluctuations of the market do not impact on my global balance. Therefore, instead of getting two forwards as in option 1, I'd wait until the first transaction date and then get a forward for the second transaction.

Option 1 gives me the security that on the 1st transaction date I won't have any cash flow surprise, but I have to pay bank fees for 2 forwards that in some part of the time "compensate each other". Imagine the two future days differ on just one day: the exchange risk is very low and it's probably not worth to get a forward at all.

Now imagine the first transaction is one year in the future and the second is 2 years in the future. With 2 forwards I'll pay for "3 years of uncertainty" (1 of the 1st transaction + 2 of the 2nd one), but the risk is only in the second year, not the first, so there is just "one year of uncertainty". But still, at the end of the 1st year, I don't want a surprise with the first exchange.

Which is the best product that solves this problem? I've read about swaps, but I don't know if a swap can be subscribed with an initial transaction in the future...? Is there the option to assure today an initial exchange and a final exchange, both in the future, that takes into account only this 1 year risk?

Thank you!

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Option 1 if your objective is to reduce risk. But do them together as a swap.

What you described is a Fx FRA (Forward Rate Agreement, aka Forward Forward, aka Forward starting FX Swap). These are frequently traded. These will be cheaper for you to trade than to trade one leg at a time. You and the dealing counterpart will be taking less risk if you buy and sell the currency at the same time. You will eliminate most of the FX risk in that you will buy and sell the currency at the same time (with uneven swaps there will be slight FX risk but it is still reduced by selling and buying the currency and the dealer will charge you less to take on just the residual risk) and the risk will essentially be reduced to just the funding costs. Any time you reduce the risk of your counterparty, all else equal, you will pay less.

So for your example: You Buy 1000 USD (Sell EUR) @ 1.18 USD/EUR in one year, and you Sell 1000 USD (BUY EUR) @ 1.19 USD/EUR. On the FX Forward Starting Swap, you will pay 847.4576 EUR a year from now and receive 1000 USD. The following year, you will have to pay 1000 USD and you will receive 840.3361 EUR. However you will earn 1 year of USD interest on your 1000 USD (say 1%, or 10 USD) and that will have some FX risk associated with it. To eliminate the FX risk on this piece, you should agree to sell 1010 USD on the far leg of the FX Forward Starting Swap. In this case you will receive 848.7395 EUR. In this example, you would have earned 1.28 EUR. This is an example of what is known as an FX Carry trade. These are not real numbers and just an example. In the current market, you will only earn about 0.1% on this will be a negative carry trade for you.

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  • $\begingroup$ That was very clarifying, thank you! If the amounts are different, is it better to have 2 different forwards or an Fx FRA for the common amount and then a forward for the difference? (should I open a new question with that?) $\endgroup$ – xavier Oct 2 '20 at 9:36
  • $\begingroup$ After reading you answer again and again, I think that my question is already answered when you say "with uneven swaps..." $\endgroup$ – xavier Oct 2 '20 at 11:33
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    $\begingroup$ Yes. Most fx swaps will be slightly uneven due to the interest earned in the foreign currency. Even with the amounts different by large amounts, unrelated to the interest, you should still trade them as a swap. The reason being is that the net risk is what matters. If you are trading both at the same time, as in the fx swap, you won't have to cross the full bid-ask spread on both legs. $\endgroup$ – AlRacoon Oct 2 '20 at 12:53
  • $\begingroup$ Thanks! I see one problem, though: it's very unlikely that I find someone who wants to trade exactly the same amount as me (with opposite directions) on both dates. I guess that I don't need to find that person but all these is solved by "the market" and/or the bank, right? $\endgroup$ – xavier Oct 2 '20 at 13:23
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    $\begingroup$ Yes. The banks/dealers stand ready to make a market in these. When you do an fx swap, you are reducing the risk to financing. Banks are in the business of financing. $\endgroup$ – AlRacoon Oct 2 '20 at 13:32

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