Updated July 7, 2023
What is a Currency Swap?
The term “currency swap” refers to the agreement between two parties who intend to exchange the interest payment and the principal amount, sometimes in one currency, with that of another.
The interest rate can be either floating or fixed rates denominated in two different currencies. These derivative contracts are valid for a specified period only, which could go up to 10 years, based on the terms and conditions of the agreement.
Explanation
Firms primarily use currency swaps to access foreign currency loans at a relatively cheaper interest rate than borrowing directly from a foreign market. These contracts are also used as a hedging measure for transaction risk on borrowed foreign currency loans.
How Does Currency Swap Work?
Now, let us have a look at the step-by-step working of it.
- Step 1: At the origination of a currency swap, the principal amounts are exchanged between the two parties at the spot rate.
- Step 2: During the currency swap, each party must pay the interest on the other’s principal loan amount.
- Step 3: At the end of the currency swap, both parties swap back their respective principal loan amounts at a pre-determined or prevailing spot rate.
Example of Currency Swap
Let us take the example of a US-based company XYZ Inc. which will be able to borrow in the US at an interest rate of 5%, but the company requires a loan in Pound sterling for investment in the UK, where the prevailing interest rate is 8%. At the same time, a UK-based company ABC Plc. The intention is to invest in a US project, where borrowing directly at 9% is possible compared to the UK’s 6% interest rate.
So, both parties can benefit by entering into a fixed-for-fixed currency swap contract. In this case, the US-based company XYZ Inc. can borrow a US dollar loan at 5% and then lend the proceeds to the UK-based company ABC Plc. at that rate. On the other hand, the UK-based company ABC Plc. can borrow a Pound sterling loan at 6% and then lend it to the US-based company XYZ Inc.
In the above example, XYZ Inc. saved 2% (= 8% – 6%) in interest rate, while ABC Plc. saved 4% (= 9% – 5%). This is how the participating parties benefit from a currency swap.
Types of Currency Swap
Based on the different types of legs involved in a contract, the currency swaps agreement can be mainly classified into the following three types:
- Fixed vs Float: In this type of currency swap, the interest payment at a fixed rate is swapped with a floating interest rate.
- Float vs Float: In this type of currency swap, both the interest payments are at the floating rate to change the tenor of the benchmark index. It is also known as a basis swap.
- Fixed vs Fixed: In this type of currency swap, both the interest payments are at a fixed rate. It is the case explained in example 1 in the previous section.
Currency Swap Agreement
A currency swap agreement refers to a contract between two countries, preferably between their central banks, who intend to exchange currencies per the pre-determined terms and conditions. Such an agreement aims to avoid volatility and other risks associated with the foreign exchange market. It promotes bilateral trade, helps maintain foreign exchange reserves, and ensures financial stability.
Uses
Some of its most important uses of it are as follows:
- First, to access the relatively cheaper borrowing cost irrespective of the loan’s currency.
- To hedge against fluctuations in the forwarding exchange rate.
- To safeguard against financial instability, an entity can borrow money in its currency from others, ensuring the ability to support liquidity crises.
Risks of Currency Swap
It exposes the users to the following risks:
- Its value changes as interest and foreign exchange rates fluctuate, exposing the users to delta and basis risks.
- In the case of an uncollateralized currency swap, there is no credit support annex which exposes the trading parties to funding and credit risks.
- In the case of collateralized currency swaps, there is always risk about the collateral per se.
Benefits of Currency Swap
Some of the significant benefits are as follows:
- It helps portfolio managers to regulate their exposure to the prevailing interest rate.
- Currency swaps reduce various costs and risks associated with currency exchanges.
- In favorable market situations, companies take advantage by exchanging fixed-rate liabilities with floating-rate swaps and vice versa.
- It minimizes the risk of uncertainty associated with future cash flows as currency swaps let counterparties change their debt conditions.
Disadvantages of Currency Swap
Some of the major disadvantages are as follows:
- Credit risk exposes users to the possibility of default on interest payment by either party or parties in this derivative contract.
- The involvement of the central government in the exchange market amplifies the impact of catastrophic currency exchange rate movements on domestic currency value.
Conclusion
A currency swap is a contractual agreement between two counterparties to exchange currencies based on predetermined terms and conditions. The primary objective is to circumvent the volatilities and risks associated with the foreign exchange market. Governments and central banks use currency swaps to enhance trade relationships and maintain foreign currency reserves.
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This is a guide to Currency Swaps. We also discuss the introduction, how currency swaps work, and their benefits and disadvantages. You may also have a look at the following articles to learn more –
