Tom-Next (Tomorrow-Next)

Tom-next, short for tomorrow-next and often written T/N, is a very short FX swap. Two parties exchange two currencies for value tomorrow and agree at the same time to reverse the exchange on the following business day. The effect is to borrow one currency and lend the other for a single day, or equivalently to move the settlement of an existing currency position back by one day.

The transaction exists because of the way foreign exchange settles. A spot trade settles two business days after it is dealt, on the spot date. A dealer or investor who opened a position yesterday and does not want to deliver the currency faces settlement tomorrow. A tom-next swap pushes that settlement from tomorrow to the day after, which is the current spot date, and it can be repeated each day for as long as the position is held.

The market quotes several one-day swaps, named after their two value date legs.

• Overnight (O/N). From today to tomorrow.
• Tom-next (T/N). From tomorrow to the next business day, which is normally the spot date.
• Spot-next (S/N). From the spot date to the business day after it.

Overnight and tom-next both settle before spot and are known as pre-spot or short-dated swaps. Because their first leg falls very soon, they must be dealt before the payment cut-off times of the currencies involved. For currency pairs that settle spot in one day instead of two, the overnight swap does the job that tom-next does elsewhere.

A tom-next swap is quoted in swap points, the difference between the exchange rate on the far leg and the rate on the near leg. The points reflect the interest rate differential between the two currencies for the period. A close approximation is:

• $S$ is the spot rate, expressed as units of the quote currency per unit of the base currency.
• $i_q$ is the annual interest rate on the quote currency, as a decimal.
• $i_b$ is the annual interest rate on the base currency, as a decimal.
• $d$ is the number of calendar days covered, with 360 as the day-count base for most currencies and 365 for some, such as sterling.

Take euro against US dollar at a spot rate of 1.1000, with one-day dollar rates at 5 percent and euro rates at 3 percent. For one day the points are 1.1000 multiplied by 0.02, divided by 360, which is about 0.000061, or 0.61 of a pip. The dollar has the higher interest rate, so the euro is worth slightly more for the later date. A party holding euros and owing dollars through the swap earns the lower rate and pays the higher one, and the points are a cost. The opposite position receives the points.

Actual quotes show a bid and an offer, and they move with money market conditions. Over quarter-ends and year-ends, when banks are reluctant to lend, the implied cost of borrowing a currency for one day through the swap market can rise well above normal levels.

Bank dealers use tom-next to carry positions from one day to the next without taking or making delivery, and treasury desks use it to manage short-term cash in each currency. A company that has sold foreign currency for spot settlement but finds the receipts will arrive a day late can use a short-dated swap to bridge the gap. Payment firms and banks use the same instruments for nostro funding, covering a shortfall in one currency account with a surplus in another.

The widest use is in margin trading. Retail foreign exchange and contract-for-difference brokers do not deliver currency to their customers. Each open position is rolled forward daily, and the broker credits or debits the account with a financing adjustment based on the tom-next rate plus its own markup. Brokers call this the rollover, swap or overnight financing charge. Because of the two-day settlement lag, the roll applied on a Wednesday usually covers three days, to account for the weekend.

Tom-next points are the daily building block of carry trade returns. An investor who is long a high-interest currency against a low-interest one receives the points each day the position is rolled, and one who is short pays them. Over time these small daily amounts add up to roughly the interest differential.

The same arithmetic produces the forward exchange rate for longer dates. A one-month FX forward contract is priced as spot plus one month of swap points, and rolling a position tom-next every day for a month achieves a similar economic result, with the difference that the daily rates are not known in advance.

Each roll is a pair of real payments, so short-dated swaps carry settlement risk and consume credit lines, although much interbank volume settles through Continuous Linked Settlement. The cost of rolling is uncertain from one day to the next, which matters for positions held a long time. Retail customers should note that broker financing charges include a markup and are frequently unfavorable in both directions, so a position can incur a cost whichever currency has the higher interest rate.