Question

Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many instances for hedging purposes. How does a bank mitigate the currency exposure it has created for itself by accommodating the clients’ forward transaction?

Answer 1

The bank mitigate the currency exposure in a forward trade through swap transactions. A swap transaction is the simultaneous sale or purchase of spot foreign exchange against a forward purchase or sale of an approximately equal amount of the foreign currency.

In currency swap transactions the foreign currency rate may be taken advantage of by banks due to the arbitrage. An arbitrage is the difference in the exchange rate between two different markets.

Example: suppose a bank customer wants to buy Euro three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against Euro. The bank will lend the Euro for three months until they are needed to deliver against the Euro it has sold forward. The British pounds received will be used to liquidate the sterling loan.