FX swaps and repo are closely related: both are driven by short-term interest rates and can be used to finance asset positions. The pricing of FX swaps, both against repos and, in particular, the short term interest rates used to hedge those swaps, should prevent arbitrage opportunities – but this is simply not the case. Mispricing and arbitrage opportunities exist based on central bank intervention, client needs and additional factors. Repo market professionals should understand the FX markets and vice versa.
This report is a primer on the FX swaps market with an emphasis on the connection to the USD repo markets. Both markets are driven by many of the same forces, however, securities finance and FX swap and forward markets are often managed separately at banks and investment firms. Repo desks are either part of securities financing silos or cash trading desks. FX swaps and forwards are typically embedded in FX businesses. Securities finance traders, including those working for investment managers, should understand when dislocations in these markets occur, what it means for their markets and clients, and how to assess multiple products to take advantage as opportunities present themselves.
FX swaps pricing is based on the idea of Covered Interest Parity (CIP). This was once thought of as a fixed rule, but repeated breaks have shown this to be incorrect. CIP posits that any riskless arbitrage in FX swaps and forwards will be arbitraged out immediately. However, firms without natural sources of dollars (i.e., those without the ability to access local USD repo lines or are unable to issue USD Commercial Paper or Certificates of Deposit) may fund themselves using FX swaps, leading to continued demand to borrow USD in the FX swaps market. In frictionless markets, participants would commit capital to push the prices back to an arbitrage-free equilibrium, but that is not the world we live in. Repo market participants have an opportunity to take advantage of these breaks in CIP, with caveats.
This report demonstrates the mechanics of FX swaps in the context of repo trading, including why investors prefer one product over another, balance sheet treatment and global vs. local market dynamics. It should be read by repo and FX dealers, and clients including investment managers.
A direct link for Finadium subscribers to this report is https://finadium.com/finadium-report-desc/fx-swaps-and-the-repo-market/
For non-subscribers, more information is available here.