Currency swap

A currency swap is a foreign-exchange agreement between two parties to exchange

aspects (namely the principal and/or interest payments) of a loan in one currency for
equivalent aspects of an equal in net present value loan in another currency; see Foreign
exchange derivative. Currency swaps are motivated by comparative advantage. A swap
that involves the exchange of principal and interest in one currency for the same in
another currency. It is considered to be a foreign exchange transaction and is not required
by law to be shown on the balance sheet.

In other words

A currency swap is an agreement between two parties to exchange the principal loan
amount and interest applicable on it in one currency with the principal and interest
payments on an equal loan in another currency. These contracts are valid for a specific
period, which could range up to ten years, and are typically used to exchange fixed-rate
interest payments for floating-rate payments on dates specified by the two parties.

Since the exchange of payment takes place in two different currencies, the prevailing spot
rate is used to calculate the payment amount. This financial instrument is used to hedge
interest rate risks.

Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate
swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of
the principal.

There are three different ways in which currency swaps can exchange loans:

The most simple currency swap structure is to exchange the principal only with the
counterparty, at a rate agreed now, at some specified point in the future. Such an
agreement performs a function equivalent to a forward contract or futures. The cost of
finding a counterparty (either directly or through an intermediary), and drawing up an
agreement with them, makes swaps more expensive than alternative derivatives (and thus
rarely used) as a method to fix shorter term forward exchange rates. However for the
longer term future, commonly up to 10 years, where spreads are wider for alternative
derivatives, principal-only currency swaps are often used as a cost-effective way to fix
forward rates. This type of currency swap is also known as an FX-swap.
Another currency swap structure is to combine the exchange of loan principal, as above,
with an interest rate swap. In such a swap, interest cash flows are not netted before they
are paid to the counterparty (as they would be in a Vanilla interest rate swap) because
they are denominated in different currencies. As each party effectively borrows on the
other's behalf, this type of swap is also known as a back-to-back loan.

Last here, but certainly not least important, is to swap only interest payment cash flows
on loans of the same size and term. Again, as this is a currency swap, the exchanged cash
flows are in different denominations and so are not netted. An example of such a swap is
the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments
in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross-
currency swap.

Uses
Currency swaps have two main uses:

• To secure cheaper debt (by borrowing at the best available rate regardless of
currency and then swapping for debt in desired currency using a back-to-back-
loan).
• To hedge against (reduce exposure to) exchange rate fluctuations

Hedging Example

For instance, a US-based company needing to borrow Swiss Francs, and a Swiss-based
company needing to borrow a similar present value in US Dollars, could both reduce
their exposure to exchange rate fluctuations by arranging any one of the following:

• If the companies have already borrowed in the currencies each needs the principal
in, then exposure is reduced by swapping cash flows only, so that each company's
finance cost is in that company's domestic currency.
• Alternatively, the companies could borrow in their own domestic currencies (and
may well each have comparative advantage when doing so), and then get the
principal in the currency they desire with a principal-only swap.
 History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange
controls in the United Kingdom. At that time, UK companies had to pay a premium to
borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements
with US companies wishing to borrow Sterling. While such restrictions on currency
exchange have since become rare, savings are still available from back-to-back loans due
to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain
Swiss francs and German marks by exchanging cash flows with IBM. This deal was
brokered by Salomon Brothers with a notional amount of $210 million dollars and a term
of over ten years.

During the global financial crisis of 2008, the currency swap transaction structure was
used by the United States Federal Reserve System to establish central bank liquidity
swaps. In these, the Federal Reserve and the central bank of a developed or stable
emerging economy agree to exchange domestic currencies at the current prevailing
market exchange rate & agree to reverse the swap at the same exchange rate at a fixed
future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S.
dollars to overseas markets." While central bank liquidity swaps and currency swaps are
structurally the same, currency swaps are commercial transactions driven by comparative
advantage, while central bank liquidity swaps are emergency loans of US Dollars to
overseas markets, and it is currently unknown whether or not they will be beneficial for
the Dollar or the US in the long-term.

The People's Republic of China has multiple year currency swap agreements of the
Renminbi with Argentina, Belarus, Hong Kong, Indonesia, Malaysia, and South Korea
that perform a similar function to central bank liquidity swaps.

How Does a Currency Swap Work?

A currency swap agreement specifies the principal amount to be swapped, a common

maturity period and the interest and exchange rates determined at the commencement of
the contract. The two parties would continue to exchange the interest payment at the
predetermined rate until the maturity period is reached. On the date of maturity, the two
parties swap the principal amount specified in the contract.

The equivalent amount of the loan value in another currency is calculated by using the
net present value (NPV). This implies that the exchange of the principal amount is carried
out at market rates during the inception and maturity periods of the agreement.
Benefits of Currency Swaps
The benefits of currency swaps are:

• Help portfolio managers regulate their exposure to interest rates.

• Speculators can benefit from a favorable change in interest rates.
• Reduce uncertainty associated with future cash flows as it enables companies to modify
their debt conditions.
• Reduce costs and risks associated with currency exchange.
• Companies having fixed rate liabilities can capitalize on floating-rate swaps and vise versa,
based on the prevailing economic scenario.

Limitations of Currency Swaps

The drawbacks of currency swaps are:

• Exposed to credit risk as either one or both the parties could default on interest and
principal payments.
• Vulnerable to the central government’s intervention in the exchange markets. This happens
when the government of a country acquires huge foreign debts to temporarily support a declining
currency. This leads to a huge downturn in the value of the domestic currency.

Who would use a swap?

The motivations for using swap contracts fall into two basic categories: commercial needs and
comparative advantage. The normal business operations of some firms lead to certain types of
interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which
pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on
loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous
difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to
convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-
rate liabilities.

Some companies have a comparative advantage in acquiring certain types of financing. However,
this comparative advantage may not be for the type of financing desired. In this case, the
company may acquire the financing for which it has a comparative advantage, then use a swap to
convert it to the desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations into Europe,
where it is less well known. It will likely receive more favorable financing terms in the US. By then
using a currency swap, the firm ends with the euros it needs to fund its expansion.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination
date. This is similar to an investor selling an exchange-traded futures or option contract before
expiration. There are four basic ways to do this.

1. Buy Out the Counterparty

Just like an option or futures contract, a swap has a calculable market value, so one party
may terminate the contract by paying the other this market value. However, this is not an
automatic feature, so either it must be specified in the swaps contract in advance, or the
party who wants out must secure the counterparty's consent.

2. Enter an Offsetting Swap

For example, Company A from the interest rate swap example above could enter into a
second swap, this time receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else

Because swaps have calculable value, one party may sell the contract to a third party. As
with Strategy 1, this requires the permission of the counterparty.

4. Use a Swaption
A swaption is an option on a swap. Purchasing a swaption would allow a party to set up,
but not enter into, a potentially offsetting swap at the time they execute the original
swap. This would reduce some of the market risks associated with Strategy 2..