When selling one currency and buying another, the underlying interest rate costs may make a huge difference to your portfolio profitability. In this post, we look at how FX swap costs work, and explain how monitoring them can improve your odds of a good deal.
Understanding the FX Swap Market
According to the latest Triennial Central Bank Survey by BIS, trading in OTC FX markets reached a staggering $7.5 trillion per day in April 2022, up 14% from the $6.6 trillion traded per day just three years earlier. Meanwhile, the turnover of FX swaps accounted for 51% of the global turnover, up from 49% in 2019; and the US dollar was on one side of 88% of all trades (unchanged from 2019).
All this shows just how vast the FX swap market is, and how quickly it can all change. This is why it’s so imperative to monitor any shifts in the market if you want to keep your forex trading costs down.
How FX Swap Costs Impact Your Portfolio Returns
To better understand how all this works in terms of FX swap costs, let’s take three of the top currencies as an example.
Currently, central banks’ interest rate differential between the UK and the US is much smaller than that between the EU and the UK. This means that:
- If you have a portfolio in GBP with investors in USD, and you want to hedge the currency rate risk, you’ll need to sell GBP and buy USD, which in the current swap market would provide 22 positive basis points (bps) per annum.
- For EUR investors, however, the opposite is true, because the European Central Bank’s rate is lower than the UK’s rate, meaning that buying EUR and selling GBP currently costs 182 bps per annum.
Moreover, in the last two years, the EUR/GBP volatility has been around 7.7%, but the volatility of GBP/USD was double that, hovering at around 14.4%. Monitoring this volatility, therefore, would have been key to deciding when and what currencies to exchange.
When is it Convenient to Work With FX Swaps?
Well, there is no definite answer to this question, because investment decisions are based on risk appetite.
If we look at the example of the GBP portfolio with FX swaps in EUR and USD, from a risk point of view, they are very different today. In fact, hedging the USD generates a small positive carry return, so you hedge the risk and make a few basis points, resulting in null FX swap costs.
The EUR is completely different, however, because the volatility of the pair is half of the USD, but it’ll cost you around 2% per annum. In case your investment in GBP is generating 6% per annum, adding the 2% cost has a large impact, taking your profit down to 4% net.
In other words, if the volatility of the currency is 7% and the cost is 2%, you’ll need to decide whether it is convenient for you to pay such a cost to cover a three-times risk.
So, while there is no right answer to such a question, it does help to do proper risk management and understand your position upfront.
Monitor FX Swap Costs for Better Decision-Making
Once you have identified your investment risk metrics, it’s important to monitor the forex market swap costs and the impact they’ll have on your portfolio. One way of easily and accurately doing that is by investing in software that is connected to multiple counterparties and which can keep tabs on the ups and downs of these costs.
Our investment strategy automation software, CYBMIND, which comes with integrated Spotfire® capabilities, lets you monitor FX swap costs in real-time, empowering your decisions and reducing the chances of any nasty surprises.
So, what are you waiting for? Get in touch with us to discover how you can improve your trading cost analyses with CYBMIND and Spotfire®.