Using FX Swaps to Roll Forward Contract Hedges

Still struggling to wrap my mind around the Hedge #2 example - the mismatched swap.

Investor is based in Hong-Kong. In the example, the HKD/EUR bid/ask spread is given. The market value of the EUR has appreciated and the investor is looking to roll a short-forward contract on the EUR using an FX swap.

This involves two transactions:

  1. spot leg: buy/long equivalent EUR

  2. forward leg: sell increased amount of EUR forward to increase size of hedge to meet previous hedge ratio

It makes inherent sense to use bid side of the quote for the forward leg given we are selling the EUR in a HKD/EUR quote. However, the curriculum also indicates we should use the bid side of the quote for the spot leg.

Why is this the case?

What side of the quote would you use if the EUR depreciated? In that case, you would buy more in the spot leg than you would be selling in the forward leg. Would you use the OFFER for both transactions?

This is about the continuation of a hedge for your EUR exposure. Your forward is about to expire and you are looking to prolong it by entering into a SWAP. Because the EUR has appreciated since you entered into a forward, you need to increase the size (Basically the trade has been working against you, so you need to make up for to maintain the hedge). In addition, it is expected that the EUR will depreciate in the coming months (which supports you wanting to take advantage by increasing the size of your short forward on EUR).

–> you want to prolong your forward --> this is done by entering into a SAWP --> your dealer gives you ONE quote for this ONE trade --> the bid side (because you continue to sell EUR forward. HKD/EUR bid-ask quote, we sell EUR forward at the bid side.

What I am trying to say is that, due to the fact that we are prolonging an existing forward, we should only worry about one quote (either bid or offer) even though we are dealing with a spot leg (buy EUR to settle existing forward) and forward leg (continue to sell EUR forward).

Thanks @Mr RS. So is the appropriate side of the quote always determined by the forward leg of the swap?

In a situation where you have an existing forward that you prolong by entering into a SWAP (either matched or mismatched), yes, because the curriculum teaches us that the forward leg of the SWAP takes precedence.