Banks determine it essential to accommodate their client's needs to purchase or sell foreign exchange forward, in several instances for hedging purposes. How can the bank abolish the currency exposure it has formed for itself by accommodating a client's forward transaction?
Swap transactions offer means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against forward purchase (or sale) of an approximately equivalent amount of the foreign currency. To demonstrate, suppose a bank customer desires to buy dollars three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade through selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months till they are required to deliver against the dollars it has sold forward. The British pounds received will be utilized to liquidate the sterling loan.