Summary of WP/93/64: “The Use of Foreign Exchange Swaps by Central Banks: A Survey”

This compilation of summaries of Working Papers released during July-December 1993 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street N.W., Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201

Abstract

This compilation of summaries of Working Papers released during July-December 1993 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street N.W., Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201

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.

Working Paper Summaries (WP/93/55 - WP/93/95)
Author: International Monetary Fund