Foreign exchange swap or simply an FX swap is an exchange of loan in two different currency notionals, with a near and far leg to denote the initial exchange of loan and a final reversal to close the swap contract respectively. For instance a 6-month USDKRW FX swap for a notional of USD 100 mio would typically have a t+2 near leg that uses the USDKRW spot rate to exchange the initial loan amounts in the respective currencies and reverses the loan arrangement at the end of 6 months using the 6 month USDKRW forward rate. Benchmark currency notional (in this case USD) stays as is for both the near and far leg, with the cost of exchanging USD for KRW reflected in the final KRW loannotional exchanged at the far leg to close the swap.
Forward exchange rate for any tenor in the real marketplace is the sum of FX Spot and points for that forward tenor; also called the forward rate as implied by FX points. Finance 101 talks about FX points implying the interest rate differential between the Local and benchmark currency or as purists would say the ratio of FX implied local currency zero rate and the benchmark/foreign currency zero rate. In the real world however interest rate parity is seldom fulfilled especially for economies that run large surplus dollar savings and hence dollar-based investments that create large spot USD demand to fund these investments – South Korea and Taiwan are cases in point in Asia. The difference between the real marketplace FX points and FX points implied by interest rate differential is popularly referred to as the cross-currency FX ‘basis’.
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