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, in some cases, 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.
Currency swaps are primarily used to access foreign currency loans at a relatively cheaper interest rate than a firm could get by 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 rate or the 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. It intends to invest in a project in the US, where it will be able to borrow directly at 9% compared to an interest rate of 6% in the UK.
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 swap contract between two countries, preferably between their central banks, who intend to exchange currencies in line with 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.
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 with the ability to support its liquidity crisis as it can borrow money from others with its currency.
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.
- It reduces various costs as well as risks that are 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:
- In this type of derivative contract, either party or both parties may default on the interest payment, exposing the users to credit risk.
- Given the involvement of the central government in the exchange market, any catastrophic movement in the currency exchange rate can result in a significant decline in the domestic currency’s value.
So, it can be seen that a currency swap is a contract between two counterparties for swapping currencies as per pre-determined terms and conditions. The primary objective is to circumvent the volatilities and risks associated with the foreign exchange market. Further, governments and central banks also participate in currency swaps to foster bilateral trade relationships with other countries and maintain adequate foreign currency reserves.
This is a guide to Currency Swap. Here 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 –