Currency swaps allow two parties to exchange interest payments and principal on loans denominated in different currencies. For example, a British company issuing bonds in pounds could use a currency swap to exchange its pound-denominated debt obligations for dollar-denominated obligations to fund a project in the US. Similarly, a US company could issue dollar bonds but use a currency swap to take on pound obligations to fund a project in the UK. The currency swap protects both parties from exchange rate risk over the life of the loans. However, there is credit risk if one party defaults on exchanging the principal amounts at maturity. Parties employ collateral, netting agreements, credit derivatives and marking to market to mitigate this risk.

1. CURRENCY
SWAPS

2. B.Saiprakash
MBA [IM]
PondicherryUniversity

3. An Introduction to Swaps
 A swap is an agreement between counter-parties to
exchange cash flows at specified future times according
to pre-specified conditions.
 A swap is equivalent to a coupon-bearing asset plus a
coupon-bearing liability. The coupons might be fixed or
floating.
 A swap is equivalent to a portfolio, or strip, of forward
contracts--each with a different maturity date, and each
with the same forward price.

4. currency swaps
A currency swap is a foreign-exchange
agreement between two institute to exchange
aspects (namely the principal and/interest
payments) of a loan in one currency for
equivalent aspects of an equal in net present
value loan in another currency.
A currency swap should be distinguished from
a central bank liquidity swap.

5. Example
 As a example, 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 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.

6. Example
To meet each other's needs, suppose
that both companies go to a swap
bank that sets up the following
agreements:

7. Example
Agreement 1:
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.
2. The Piper Company will issue 5-year $150 million
bonds. 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.

8. Example
Agreement 2:
1. The British company, with its U.S. asset will pay
the 10% interest on $150 million to the swap bank
who will pass it on to the American company so it
can pay its U.S. bondholders.
2. The American company, with its British asset will
pay the 7.5% interest on £100 million to the swap
bank who will pass it on to the British company so
it can pay its British bondholders.
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9. Example
Agreement 3:
1. 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.
2. 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.
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10. Uses of CURRENCY
SWAPS
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

11. HEDGE
Instead of forward contracts, the swap bank
also could hedge its swap position by using
a money market position.
For example, on its first sterling liability of
£500,000 due in one year, the bank would
need to create a sterling asset worth
£500,000 one year later and a dollar
liability worth $764,524 .

12. Typical Uses of a
Currency Swap
To convert a liability in one currency
into a liability in another currency.
To convert an investment (asset) in
one currency to an investment in
another currency.

13. Credit Risk: Currency
Swaps
Note that there is greater credit risk with a
currency swap when there will be a final
exchange of principal.
This means that there is a higher
probability of a large buildup in value,
giving one of the counter-parties (the one
who is losing) the incentive to default.

14. Credit Risk
No credit risk exists when a swap is first created.
The credit risk in a swap is greater when there is
an exchange of principal amounts at termination.
Only the winning party (for whom the swap is an
asset) faces credit risk. This risk is the risk that
the counter-party will default.
Many vehicles exist to manage credit risk:
Collateral or collateral triggers
Netting agreements
Credit derivatives
Marking to market