Central banks have long engaged in foreign exchange swaps with other central or commercial banks by exchanging, on the initial and maturity dates, principal amounts at agreed exchange rates. Their primary reasons for participating in swaps are to affect domestic liquidity, manage their foreign exchange reserves, and stimulate domestic financial markets. This paper describes how foreign exchange swaps work and the various ways in which central banks have used them to achieve their goals.
Foreign exchange swaps are priced by markets according to the covered interest parity condition, after allowing for maturity, tax treatment, transaction costs, and default, “Herstatt,” and sovereign risk. If cover is not maintained, a swap may expose the participants to significant foreign exchange risk. The paper explains how a central bank must also consider the effect of its swaps on domestic liquidity. If not fully sterilized, a swap with a domestic bank will be reflected in a movement in reserve money.
Swaps have been used as a domestic monetary policy instrument in a number of industrial countries (notably Switzerland) and several developing countries (for example, Malaysia, Oman and Turkey). Central banks like to use swaps, which offer flexibility, especially when the domestic securities market is not deep (or is nonexistent) and when the direct effect on the spot exchange rate of outright foreign exchange operations is to be avoided. However, the popularity of swaps has declined as other instruments have been developed.
Central banks have used foreign exchange swaps to manage the risk and return obtained on foreign exchange reserves or to acquire reserves in specific currencies. In addition, the central banks of some countries (for example, Argentina, Chile, and Korea) have resorted to swaps to obtain foreign exchange reserves in conditions of scarcity. In other cases, foreign exchange guarantees were extended to favored sectors or activities, which is tantamount to establishing a swap facility.