Currency swaps were originally conceived as a way to avoid the foreign exchange transaction costs that were associated with international trade. By using an intervening currency, parties would be able to reduce these costs and improve their terms of trade by locking in a favorable rate for future transactions.
Today, currency swaps are used by corporations and governments alike as a means of hedging against adverse movements in exchange rates. They also allow companies the opportunity to capitalize on interest rate differentials (although these days cross-currency basis swaps are often used for this purpose).
In this article, we are going to dig in and look at what currency swaps are, some examples, and their benefits.
Currency Swap Definition
A currency swap is a derivative contract between two parties, also known as counter-parties. It involves an exchange of principal and interest in one currency for the same in another currency at certain intervals for a pre-agreed period.
Swap contracts normally state that the original principal amounts should be repaid in full at the end of the period, though this can be extended if both parties agree.
The contract defines the dates on which interest payments are due and how the exchanged principal amounts are calculated.
Currency Swap Example
For example, if Mr. A wants to borrow $1 million for 3 years from Mr. B; Mr. A may enter into a currency swap deal with Mr. B, to exchange 3 yearly £1 million interest payments for a single $1 million interest payment at the end of the period.
In this example, if Mr. A borrows from an American bank and wants to exchange his GBP interest payments for USD interest payments during the 3 years, he can enter into a currency swap contract with Mr. B, and exchange his GBP interest payments for USD interest payments.
At the end of the period, he would repay $1 million to Mr. B as well as pay $1 million worth of GBP revenue to Mr. A (although this figure may change over time due to changes in FX rates).
Currency Swap Benefits
The principal benefit of a currency swap is that it allows an individual or business to manage exchange rate risks. This can be done by taking out a hedge between two currencies so that the value of liabilities and assets remains constant in either one currency or another.
Here are a few benefits of Currency Swap
- It allows businesses to reduce their risk by transferring interest rates or currency exposures to another party
- It allows banks to be exposed to the credit quality of the borrower while fully hedging against exchange rate risk
- It allows for more complex transactions with greater customization, which is difficult with cross-currency basis swaps
- It provides a mechanism that enables businesses to lock in a specific exchange rate for future transactions
- It allows banks and borrowers to capitalize on interest rate differentials between two currencies without exchanging principal amounts until the final maturity date (although this is also available with cross-currency basis swaps)
Currency swaps are powerful derivatives that can be used to manage the risks of foreign currencies and interest rates. They are particularly useful for businesses that depend on cross-currency transactions, or for banks that want to lock in future exchange rates. They are flexible contracts with many uses, but it is important not to focus too much on what they cannot do, and instead on how they can help you.