Forex Reserves & Forex Swap Derivatives

Forex Reserves denote the amount of reserves held by the central banks in foreign currencies. However sometimes, it also denotes the amount of gold reserves held. Forex Reserves are commonly known as international reserves held by the government or central banks. Larger reserves indicate stronger financial and economic health of the nation.

The Forex reserves help a country to prepare against unfortunate devaluation of its home currency, political calamities, natural calamities etc. The shock experience through these factors is very high and it badly affects the domestic currency. To combat the loss faced against the devaluation of the home currency, a country’s central bank always holds volumes of Forex reserves. However there are certain problems that arise in maintaining huge Forex reserves. The first and foremost problem is that, the cost of maintaining huge Forex is very high. Due to lot of external factors, the purchasing cost of Forex Reserves is quite high. Especially when the value of the foreign currency lowers, then the cost of maintaining reserves in that currency becomes all the more costly. Another problem that a nation might face while maintaining huge Forex Reserves is that, it involves extra care and effort of following the exchange rate patterns regularly.

Forex Swaps are derivative instruments that play a huge role in minimizing risk arising out of exchange rate fluctuations. It is an agreement where both the parties of a contract agree to exchange their currencies at a future period of time and then reverse it back to the original positions. In this way, the trader foregoes the risk of holding a particular currency when the interest rates become higher and when the currency, in general, becomes devalued.

There are two parts to a Forex Swap. One is the spot foreign exchange contract and other is the forward foreign exchange contract. A spot foreign exchange contract is where a transaction has a very short term, a maximum of 2 business days. Both the parties in a contract agree to complete a particular transaction within 2 days.

A forward foreign exchange contract is one where the transaction is long term and has no particular time frame. The parties in a contract agree to carry out a particular transaction at a specified future date or time. The volume of the transaction or the time period of the transaction is not fixed in a forward exchange rate contract.

A future foreign exchange contract is similar to a forward exchange contract. However the difference between both these contracts is the time limit. While the forward foreign exchange contract does not have any time limit for the transaction to be completed, the future foreign exchange contract has a time period of 3 months. Both the parties in a contract must agree on the volume of transaction to be completed and the time when the transaction has to be completed should not be more than 3 months from the current date. The volume, the interest rates and time period is fixed in a future contract. Swaps could be currency swap, equity swap, interest rate swap, derivatives swap etc.