January 2022

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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, 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.

The idea of Covered Interest Parity (CIP) 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. This report should be read by repo and FX dealers, and clients including investment managers.

Table of Contents

  • Executive Summary
  • FX Swaps as a Financing Tool
    • – FX Swaps and Forwards are Derivatives
    • – Non-Deliverable Forwards as a Separate Case
  • Covered Interest Parity
  • Investor Preferences
    • – Differences in Margin Requirements
  • Balance Sheets and Reference Rates
    • – No More LIBOR
  • FX is Global, Repo is Local
    • – FX Swaps and Repo Movements
  • About the Author
  • About Finadium LLC

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