What Is A Currency Swap? Learn Forex With FxLifeStyle
A currency swap (or a cross currency swap) is a foreign exchange derivative between two institutions to exchange the principaland/or interest payments of a loan in one currency for equivalent amounts, in net present value terms, in another currency. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from interest rate swap, for in currency swap, both principal and interest of loan is exchanged from one party to another party for mutual benefits.
Currency swaps are over-the-counter (OTC) derivatives.
There are multiple different ways in which currency swaps can exchange loans:
- The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward or futures contract. 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 a 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.
- Other structures include swapping only interest payment cash flows on loans of the same size and term, with or without fx options at the maturity of the trade. Again, as these are cross-currency swaps, the exchanged cash flows are in different denominations and so are not netted.
Suppose the British Petroleum Company plans to issue five-year bonds worth £100 million at 7.5% interest, but actually needs an equivalent amount in dollars, $150 million (current $/£ rate is $1.50/£), to finance its new refining facility in the U.S. Also, suppose that the Piper Shoe Company, a U. S. company, plans to issue $150 million in bonds at 10%, with a maturity of five years, but it really needs £100 million to set up its distribution center in London. To meet each other’s needs, suppose that both companies go to a swap bank that sets up the following agreements:
- Agreement 1:
The British Petroleum Company will issue 5-year £100 million bonds paying 7.5% interest. It will then deliver the £100 million to the swap bank who will pass it on to the U.S. Piper Company to finance the construction of its British distribution center. The Piper Company will issue 5-year $150 million bonds paying 10% interest. The Piper Company will then pass the $150 million to swap bank that will pass it on to the British Petroleum Company who will use the funds to finance the construction of its U.S. refinery.
- Agreement 2:
The British company, with its U.S. asset (refinery), will pay the 10% interest on $150 million ($15 million) to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. The American company, with its British asset (distribution center), will pay the 7.5% interest on £100 million ((.075)( £100m) = £7.5 million), to the swap bank who will pass it on to the British company so it can pay its British bondholders.
- Agreement 3:
At maturity, the British company will pay $150 million to the swap bank who will pass it on to the American company so it can pay its U.S. bondholders. At maturity, the American company will pay £100 million to the swap bank who will pass it on to the British company so it can pay its British bondholders.