Currency swaps are an indispensable financial instrument utilized by banks, multinational corporations, and institutional investors. Although these type of swaps occupation in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that total currency swaps unique and thus slightly more complicated.
A currency swap involves two parties that reciprocate a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional trade, periodic cash flows are exchanged in the appropriate currency.
First, let’s take a step back to fully illustrate the determination and function of a currency swap.
- In a currency swap, counterparties exchange equivalent amounts of two different currencies, and have dealings back at a later specified date.
- Currency swaps are often offsetting loans, and the two sides often pay each other participation on amounts exchanged.
- Financial institutions conduct most of the FX swaps, often on behalf of a non-financial corporation.
- Swaps can be adapted to to hedge against exchange-rate risk, speculate on currency moves, and borrow foreign exchange at lower interest berates.
Purpose of Currency Swaps
An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian callers (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face petiole from the unwillingness of Brazilian banks to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Party A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable predisposed rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.
While the cost of borrowing in the international store is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Public limited company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The excuse for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their townsperson lending authorities.
Currency Swap Basics
Setting up the Currency Swap
Using the example above, based on the entourages’ competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B desperate straits from an American bank while Company B borrows the funds that Company A will need through a Brazilian Bank. Both suites have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange status between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both companies require the same equivalent amount of funding, the Brazilian comrades receives $100 million from its American counterpart in exchange for 160 million Brazilian real, meaning that these notional amounts are swapped.
Plc A now holds the funds it required in real, while Company B is in possession of USD. However, both companies have to pay interest on the allowances to their respective domestic banks in the original borrowed currency. Although Company B swapped BRL for USD, it still must answer its obligation to the Brazilian bank in real. Company A faces a similar situation with its domestic bank. As a result, both fellowships will incur interest payments equivalent to the other party’s cost of borrowing. This last point makes the basis of the advantages that a currency swap provides.
Either company could conceivably borrow in its domestic currency and be a party to the foreign exchange market, but there is no guarantee that it won’t end up paying too much in interest because of exchange rate fluctuations.
Another way to believe about it is that the two companies could also agree to a swap that establishes the following conditions:
First, Entourage A issues a bond payable at a certain interest rate. It can deliver the bonds to a swap bank, which then passes it on to Theatre troupe B. Company B reciprocates by issuing an equivalent bond (at the given spot rates), delivers to the swap bank and ends up sending it to Circle A.
These funds will likely be used to pay back domestic bondholders (or other creditors) for each company. Ensemble B now has an American asset (the bonds) on which it must pay interest. Interest payments go to the swap bank, which passes it on to the American companionship and vice versa.
At maturity, each company will pay the principal back to the swap bank and, in turn, receive its beginning principal. In this way, each company has successfully obtained the foreign funds that it wanted, but at lower interest rates and without cladding as much exchange rate risk.
Advantages of the Currency Swap
Rather than borrowing real at 10%, Crowd A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Gathering A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American foundations at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B literally managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companions borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.
For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the go-between for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a sort of commission to the intermediary. Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the locality of 10 basis points. Therefore, the actual borrowing rate for Companies A and B is 5.1% and 4.1%, respectively, which is notwithstanding superior to the offered international rates.
Currency Swap Considerations
There are a few basic considerations that differentiate pampas vanilla currency swaps from other types of swaps such as interest rate swaps and return based swaps. Currency-based gizmos include an immediate and terminal exchange of notional principal. In the above example, the US$100 million and 160 million Brazilian palpable are exchanged when the contract is initiated. At termination, the notional principals are returned to the appropriate party. Company A would receive to return the notional principal in real back to Company B, and vice versa. The terminal exchange, however, exposes both coteries to foreign exchange risk, as the exchange rate may shift from its original 1.60BRL/1.00USD level.
Additionally, most swaps connect with a net payment. In a total return swap, for example, the return on an index can be swapped for the return on a particular stock. On every rapprochement date, the return of one party is netted against the return of the other and only one payment is made. In contrast, because the regular payments associated with currency swaps are not denominated in the same currency, payments are not netted. Therefore, in every determination period both parties are obligated to make payments to the counterparty.
The Bottom Line
Currency swaps are over-the-counter offshoots that serve two main purposes. First, they can be used to minimize foreign borrowing costs. Second, they could be utilized as tools to hedge exposure to exchange rate risk. Corporations with international exposure utilize these gizmos for the former purpose while institutional investors would typically implement currency swaps as part of a comprehensive hedging scheme.
It also may be more expensive to borrow in the U.S. than it is in another country, or vice versa. In either circumstance, the domestic house has a competitive advantage in taking out loans from its home country because its cost of capital is lower.