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"An FX swap, on the other hand, creates no exchange rate risk for its counterparties. This is because currencies are sold and repurchase at fixed spot and forward rates. In other words, when you sell one currency for another through an FX swap, you know from the start how much of your original currency you will get back. An FX swap is a liquidity management tool, not a risk management tool." Source: https://icmacentre.blog/2017/09/22/are-fx-swaps-and-forwards-missing-global-debt-why-the-bis-is-wrong/

However, consider the following: An Emerging Market (EM) corporate issues dollar debt and hedges its exposure by entering an FX swap agreement with an International Entity (i.e. a global bank). The EM corporate exchange the amount of Dollar that it received from bond issuance for domestic EM currency at the beginning of the contract.

In this scenario isn't, the global bank exposing herself to exchange rate risk, ceteris paribus?

1) First, the global bank needs to convert its dollar assets into the EM domestic currency in order to supply the domestic currency to the EM corporate and enter into a FX swap agreement.

2) Second, at the end of the contract the global bank will receive back an amount of EM domestic currency at a predetermined forward rate from the EM corporate. However, the global bank presumably derives "utility" from dollar assets and hence will need to convert the EM currency proceeds that she receives from the FX swap into dollars using the future spot rate.

3) The future spot rate is clearly uncertain at the time when the FX swap is initially signed, hence the global bank is exposing herself to exchange rate risk.

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However, the global bank presumably derives "utility" from dollar assets and hence will need to convert the EM currency proceeds that she receives from the FX swap into dollars using the future spot rate.

The bank already had the EM currency though, right? If they had invested it in the EM stock market or any other way they would have had to do switch the returns to dollars anyway, so this is not caused by FX swap.

If the bank did not have the EM currency before entering into the FX swap then it is buying the EM currency when the goal is actually future dollars that creates the exchange rate risk, not FX swap itself.

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  • $\begingroup$ I am interested in the second case. Yes, but the exchange rate risk arises exactly as a consequence of the fact that the global bank is choosing to enter into an FX swap contract. I surely agree that an FX swap agreement does not lead to an exchange rate risk per se; however, once we account for how the positions are funded then we must acknowledge the existence of an exchange risk. $\endgroup$ – night_owl89 Jun 12 '18 at 18:08
  • $\begingroup$ By looking at such a complex picture you would get a lot of 'it depends' answers. The swap is usually made between parties who already have the requisite currencies or aim to have them. Of course if one does not wants the currency and buys it solely for the purpose of the swap, then it becomes risky, but again, the risk here comes from buying the currency, not the swap itself. $\endgroup$ – Giskard Jun 12 '18 at 18:59

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