A currency swap is a financial derivative where two parties exchange principal and interest payments of one currency for another. In a currency swap, payment streams in different currencies are exchanged at predetermined intervals and a fixed exchange rate. This allows companies to hedge currency risk, lower borrowing costs by accessing interest rates in different markets, and optimize cash flows in line with business needs. Common types of currency swaps include fixed-fixed, fixed-floating, and cross-currency swaps. An example is provided of how a US and Japanese company could use a cross-currency swap to access capital at preferable rates in each other's markets.
2. SWAPS
A Swap is an agreement between counter-parties to exchange
cash flows at specified future times according to pre specified
conditions.
It is equivalent to a coupon-bearing asset plus coupon-bearing
liability.
Types of Swaps:
1. Currency Swaps
2. Interest rate Swaps
3. Currency Swaps
• A currency swap is a financial derivative instrument and a type of
foreign exchange (forex) derivative.
• Currency swaps are typically used by companies and financial
institutions to manage their exposure to exchange rate
fluctuations, reduce borrowing costs, and meet their financing
needs in different currencies.
• It involves the exchange of principal and interest payments in one
currency for the same in another currency.
4. USES OF CURRENCY SWAPS
1. Hedging Currency Risks
A U.S. company has a subsidiary in Japan. The subsidiary generates
revenue in Japanese yen. To protect against unfavorable currency
movements, the U.S. company enters into a currency swap to convert the
yen revenue into U.S. dollars at a predetermined exchange rate.
5. USES OF CURRENCY SWAPS
2. Lowering Borrowing Costs
A European company wants to raise capital in the U.S. bond market
but can get more favorable interest rates in euros. It can enter into
a currency swap to convert the U.S. dollar-denominated interest
and principal payments into euros, reducing borrowing costs.
6. USES OF CURRENCY SWAPS
3. Minimizing Exchange Rate Impact:
A company may have a large foreign acquisition or investment and wants
to minimize the exchange rate impact on the investment's value. Currency
swaps can help stabilize the returns in the investor's home currency.
7. How Currency Swaps Work
Initial Agreement: Parties agree on the swap terms, including principal,
currencies, and exchange rate.
Currency Exchange: The initial exchange of currencies takes place.
Interest Payments: Parties make periodic interest payments based on the
swapped principal.
Maturity: On the maturity date, currencies are exchanged again at the
original exchange rate, and the swap concludes.
8. Benefits of Currency Swaps
• Risk Mitigation: Helps manage foreign exchange rate risk.
• Lower Borrowing Costs: Access to lower interest rates in different
markets.
• Cash Flow Optimization: Can align cash flows with business needs.
• Liquidity Management: Effective use of cash reserves in different
currencies.
9. Types of Currency Swaps
• Fixed-Fixed Swap: Both parties pay and receive fixed interest
rates.
• Fixed-Floating Swap: One party pays a fixed rate, and the other
pays a floating (variable) rate.
• Cross-Currency Swap: Exchange of different currencies with
variable or fixed rates.
10. An Example
• a US company, General Electric, is looking to acquire Japanese yen
and a Japanese company, Hitachi, is looking to acquire U.S. dollars
(USD), these two companies could perform a swap. The Japanese
company likely has better access to Japanese debt markets and
could get more favorable terms on a yen loan than if the U.S.
company went in directly to the Japanese debt market itself, and
vice versa in the United States for the Japanese company.
11. • Assume General Electric needs ¥100 million. The Japanese
company needs $1.1 million. If they agree to exchange this amount,
that implies a USD/JPY exchange rate of 90.9.
• General Electric will pay 1% on the ¥100 million loan, and the rate
will be floating. This means if interest rates rise or fall, so will their
interest payments.
• Hitachi agrees to pay 3.5% on their $1.1 million loan. This rate will
also be floating. The parties could also agree to keep the interest
rates fixed if they so desire.
12. • They agree to use the 3-month LIBOR rates as their interest rate benchmarks.
Interest payments will be made quarterly. The notional amounts will be repaid in
10 years at the same exchange rate they locked the currency-swap in at.
• The difference in interest rates is due to the economic conditions in each country.
In this example, at the time the cross-currency swap is instituted the interest
rates in Japan are about 2.5% lower than in the U.S..
• On the trade date, the two companies will exchange or swap the notional loan
amounts.
• Over the next 10 years, each party will pay the other interest. For example,
General Electric will pay 1% on ¥100 million quarterly, assuming interest rates
stay the same. That equates equate to ¥1 million per year or ¥250,000 per
quarter.
• At the end of the agreement, they will swap back the currencies at the same
exchange rate.
13. Challenges in Currency Swaps
• Interest Rate Risk: Fluctuations in interest rates can impact the
cost of the swap.
• Counterparty Risk: Default risk if one party fails to fulfill its
obligations.
• Liquidity Risk: Challenges in finding a willing counterparty.
• Accounting Complexity: Recording and reporting swaps can be
challenging.
• Regulatory Compliance: Compliance with international and local
regulations.