Why FX Swap Quotes Focus on Forward Points
Summary
The response explains why competitive interdealer FX swap quotes are commonly compared through their forward points even though the near leg's spot rate is not quoted. The key point is that swap present value is much more sensitive to forward points than to spot, and transaction conventions can reduce the remaining spot exposure. When currency rates differ materially, desks may use split notionals so that the near and far leg amounts are not identical; this helps offset residual present value sensitivity to spot.
Because this adjustment makes spot exposure small, counterparties can generally accept a spot rate close to the prevailing market level within the transaction's tolerance. The explanation also says that the interest rate assumption used to set split notionals need not be scrutinized very finely in developed markets because small errors have little effect under that tolerance. This is a market convention explanation, not a full valuation or execution model, and the practical tolerance and conventions can vary by transaction.
Key ideas
- FX swap value is primarily exposed to forward points, while spot sensitivity is comparatively small.
- Split notionals can reduce residual spot exposure when interest rates differ between currencies.
- A near-leg spot rate close to the prevailing market level is generally acceptable within transaction tolerance.
- The explanation relies on interdealer conventions and does not specify tolerances for every transaction.
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Full text
# Competitive quote convention for FX swaps # Competitive quote convention for FX swaps When rolling a maturing FX forward, the FX swap is quoted in forward points by the brokers for the far leg, but the spot for the near leg is not quoted. To get the most competitive quote, why do we just look at which has the most positive/least negative forward points? Why is the spot rate for the near leg not considered? ## Answer by Attack68 (score 2, accepted) https://quant.stackexchange.com/a/79632 For an FX swap the sensitivity of the PV of a transaction has small exposure to the spot FX rate, which is often mitigated by transactions conventions. The dominant risk quantity to which you are exposed is the forward points. In the interdealer market, when rates were close to zero and there was little difference between currencies, the notional on the LHS currency at spot and the forward date would be set as the same amount, e.g +10mm spot and -10mm forward. This can be typical on some client-dealer FX Swap transactions also since it is easier to define. When rates are higher now and there are bigger differences between different currencies' interest rates, a transaction mechanism called 'split notionals' is used on FX swaps in the interdealer market. If doing a 6m swap with rates at 2% in the LHS currency the notionals would now be set at +10mm and -10.1mm. The purpose of doing this is to minimise the residual PV exposure to the spot FX rates, and since this is very effective there is no real need to consider the spot FX rate at the time of pricing, since "anything" close to the prevailing spot FX rate will generally be considered acceptable within a tolerance of the agreed transaction. Similarly, the "2%" rate used to derive the split notionals is also not particularly scrutinised since getting an interest rate right within a 1bp or so is quite easy for developed markets and again makes little difference within a tolerance of the agreed transaction.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.