What is Currency Swap?
In a currency swap, interest in one currency can be swapped for interest in another currency. At regular intervals during the term of the contract, the parties agree to exchange interest payments. A business is exempt from reporting this type of transaction on its balance sheet since it involves foreign currency.
Institutional investors, banks, and MNCs all use currency swaps as a crucial tool in their toolbox. While interest rate and stock swaps work in a similar way, currency swaps are somewhat more complex due to a number of key underlying features that set them apart.
Two parties engage in a currency swap when they exchange a hypothetical principal to obtain exposure to a different currency. After the first theoretical swap, the right currency is used to swap periodic cash flows.
What is Currency Swap and how does it work?
The initial purpose of currency swaps was to circumvent exchange controls, which were government restrictions on the buying and selling of currencies. Foreign exchange restrictions are typically used by weak and developing economies to discourage speculation against their currencies. However, these days, most industrialised economies have done away with these controls.
As a result, swaps are mostly used to alter the interest rate exposure of both parties and to protect long-term assets. Currency swaps allow foreign companies to borrow money at more advantageous rates in the local currency than they would get from a local bank.
At the outset of a currency swap, the participants decide whether they will exchange the two currencies’ primary amounts. There is an inferred exchange rate between the two main amounts. If a swap were to occur if €10 million were swapped for $12.5 million, for instance, the resulting suggested EUR/USD exchange rate would be 1.25. Because both principal amounts are due at maturity, there is a chance that the market value of the dollar will have fluctuated significantly from 1.25 throughout the years, introducing exchange rate risk.
The two parties’ credit risk and interest rate curves at the beginning determine the standard method of pricing, which is stated as LIBOR plus or minus a specific number of points.
Multiple methods exist for executing a currency swap. In many swaps, the principal amounts are just used to determine the interest that is due and payable each period; they are not really exchanged.
On the maturity date, the exchange is reversed if the principle is fully exchanged when the deal is initiated. A very adaptable kind of foreign exchange, currency swap maturities are negotiable for a minimum of ten years. Both fixed and fluctuating interest rates are possible.
Setting up the Currency Swap
In the case above, Company A borrows the capital Company B requires from an American bank and Company B from a Brazilian bank due to their competitive advantages of borrowing in their domestic markets. Both companies lent to the other and swap the loans. The Brazilian company receives $100 million from its American counterpart in exchange for 160 million Brazilian real, assuming the exchange rate between Brazil (BRL) and the U.S. (USD) is 1.60BRL/1.00 USD and that both companies need the same amount of funding.
Company A has actual funds, but Company B has USD. Both corporations must pay their domestic banks interest in the borrowed currency. Although Company B swapped BRL for USD, it must pay the Brazilian bank in real. Similar issues plague Company A’s domestic bank. Both corporations will pay interest equal to the other’s borrowing cost. A currency swap’s benefits stem from this last aspect.
Either company could borrow in its local currency and enter the foreign exchange market, but exchange rate changes could increase interest costs.
The two corporations could also agree to a swap with these conditions:
- Company A issues an interest-bearing bond first. This can be done by delivering the bonds to a swap bank, which sends them to Company B, who issues an equal bond at the spot rates and sends it to Company A.
- These monies will likely repay domestic bondholders and other creditors for each company. Company B must pay interest on its American bonds. The swap bank transfers interest to the American corporation and vice versa.
- Each corporation will repay the swap bank and receive its original principal at maturity. Each company received the foreign cash it desired at cheaper interest rates and less exchange rate risk.
Exchange of Interest Rates in Currency Swaps
Interest rates can be converted in one of three ways: from one fixed rate to another, from one floating rate to another, or from one fixed rate to another. This means that in a dollar-euro swap, a borrower with a fixed interest rate in euros can trade it for either a fixed or variable rate in dollars, depending on their preference. Conversely, a borrower with a floating-rate Euro loan can swap it for a fixed-or floating-rate USD loan. One term for a swap between two floating rates is a basis swap.
Interest rate payments are typically calculated every three months and swapped every six months, though swaps can be arranged according to requirements. Since interest payments are typically denominated in multiple currencies, they are not typically netted.
Types of Currency Swaps
Plain vanilla currency swaps differ from interest rate and return based swaps, among others, in a few fundamental ways. Notional principal can be exchanged immediately or at the end of a period using currency-based instruments.
Principal and interest exchanges are the two most common kinds of cross-currency swaps. In the first scenario, the target or agreed upon exchange rate for foreign currency is established by the exchange of primary amounts between two companies. For example – in exchange for £10,000,000, US company A pledges to provide UK company B $15,000,000. The result indicates that the current or previous value of the GBP/USD exchange rate is 1.5000.
The companies will repay each other the main amounts when the contract expires. Because of this, neither company will be vulnerable to changes in the value of the currency. But, in the event that the currency rate undergoes a significant shift throughout the duration of the agreement, the two parties can agree to compensate one another with interest at a certain rate.
Or two parties agree to swap their interest rate payment responsibilities on underlying loans in the second scenario. The parties are entering into a legally enforceable agreement apart from the underlying lenders, and there is no initial exchange of principal. Both fixed and variable interest rates are possible for the payments. To lower borrowing costs or hedge against other uncertainties relating to the underlying principal amount, companies can agree to exchange interest rate payments.
A net payment is also included in the majority of swaps. One example is a total return swap, which allows investors to trade the performance of an index for that of a specific stock. One party’s return is subtracted from the other’s return and a single payment is made on each settlement date. On the other hand, payments aren’t netted in currency swaps because the periodic payments aren’t in the same currency. So, it’s imperative that both sides pay their counterparty throughout each settlement time.
What is Forex Swap?
A swap is the interest you pay or receive while you hold your positions overnight in online forex trading. The swap fee is proportional to the long/short position in the currency pair and the underlying interest rates of the two currencies.
Interest on swaps is not applicable if you make a trade and then close it the same day. In foreign exchange, certain currencies have high yields (positive) and others low yields (negative). For example, the Australian dollar (AUD) and the New Zealand dollar (NZD) are two examples of high yielding currencies. You can earn positive swap interest by buying a currency with a high yield and selling it for one with a low yield; however, the reversal is also possible.
Types of Currency Swap Contracts
Currency swaps, like interest rate swaps, can be categorised according to the types of contract legs. Here are some examples of currency swaps that you might encounter:
Fixed-For-Fixed Currency Swaps
When two currencies are swapped, one currency’s fixed interest rate payments are exchanged for another currency’s fixed interest rate payments.
Fixed-For-Floating Currency Swaps
Swapping one currency’s fixed interest rate for another’s floating interest rate is what’s known as a fixed-for-floating currency swap.
Floating-For-Floating Currency Swaps
An example of a floating-for-floating currency swap would be the exchange of one currency’s floating interest rate payments for another currency’s floating interest rate payments. For example, in a currency swap between USD and CAD, a party that prefers to pay a fixed interest rate on a CAD loan can exchange it for a fixed or floating interest rate in USD.
Interest is paid out at regular intervals, usually every three months or every six months.
Advantages of the Currency Swap
Company A must pay Company B’s 5% interest rate under its Brazilian bank arrangement instead of borrowing real at 10%. Company A successfully replaced a 10% loan with a 5% loan. Company B realises the 4% swap counterparty borrowing cost instead of borrowing from American institutions at 9%. Company B cut its debt cost by over half in this case. Both entities borrow domestically and lend to each other at lower rates than multinational banks. The currency swap diagram below shows its general properties.
The above example removes swap dealers, who facilitate currency swaps, for simplicity. As a commission to the intermediary, the dealer may raise the realised interest rate. Currency swap spreads are usually around 10 basis points, depending on the notional principals and clients. Thus, Companies A and B borrow at 5.1% and 4.1%, respectively, which is higher than worldwide rates.
Pros and Cons of Currency Swap
Swapping currencies can help to mitigate foreign exchange rate risk
Companies can borrow at a lower interest rate
Can be customized to your needs
Only available to large corporations and financial institutions
It is complex
Involve counterparty risk
Swaps in currencies are a kind of derivative that can be traded over the counter and have two primary uses. The first use is to reduce interest payments on loans taken out by foreign banks. Second, they could be a way to protect yourself from currency fluctuations. While institutional investors often use currency swaps as a comprehensive hedging strategy, corporations with worldwide exposure use these products for the former purpose.
Borrowing money in the US could cost more than in another nation, or the other way around. Because of the cheaper cost of capital in its native country, the domestic company enjoys a competitive advantage when it takes out loans from there.