Do you have any idea what currency swaps are? They are a critical instrument employed by banks and multinational corporations and investors all over the world.
A currency swap is basically a contract between two parties involving some sort of interest payment and in some cases principal amounts exchange while gaining exposure to the desired currency.
To put it in simpler words, it is an exchange of currency between two parties. It’s usually a company or bank that is the typical party of swap and not necessarily an individual.
This type of swap is also commonly known as a cross-currency swap. There are a lot of similarities between currency swaps and forex swaps and they both function in a similar manner to some extent.
However, some major differences set them apart from each other.
Difference between FOREX Swaps and Currency Swaps
According to the Bank for International Settlements (BIS), regardless of currency swap, in a forex swap, no exchange of interest occur throughout the contract term. However, the number of funds are exchanged when the contract is about to end.
Forex swaps are utilized by the parties to offset the risk of the exchange rate. Whereas a currency swap can be used to offset both interest rate as well as exchange rate risk.
Financial corporations usually use currency swaps (cross-currency swaps) to fund foreign currency investments.
The duration can range anywhere from 1 to 30 years. Whereas, conventional investors and exporters/importers frequently use forex swaps are that need to strengthen their financial positions.
The duration can range anywhere from one day to one year and in some cases, even longer.
Each of these swaps has distinctive features that make them appropriate for different purposes depending on the investment standpoint and the investor’s risk profile.
Breakdown of Currency Swap Contracts
Currency swaps generally depend on two streams of floating or fixed interest payments dubbed in two dissimilar currencies. The interest payments transfer ensues of rates that are already pre-determined.
Additionally, if the swapping parties decide to exchange principal amounts, these amounts must be swapped at the exact exchange rate on the maturity date.
Currency swaps are most often used to avoid potential risks regarding the ongoing currency exchange rate fluctuations or acquire the lowest possible interest rates on loans in a foreign currency.
However, companies or corporations that operate in different countries utilize currency swap.
Types of Currency Swaps
The classification of Currency swaps based on types of streams (legs) involved in an agreement or a contract just like a conventional interest rate swap. The most conventional types of currency swaps encountered are as follows:
Fixed vs Fixed
In a typical fixed vs fixed currency swap, both legs and streams of currency swap contracts experience payments at a fixed interest rate.
Float vs Fixed
In this type of a currency swap contract, one stream of interest payment is fixed, while the other leg represents a stream of floating interest payments.
Float vs Float
Float vs float currency swap contract is usually referred to as a basis swap. In this type of currency swap contract, both swaps streams comprise of floating interest payments.
How Does A Currency Swap Work?
For better understanding, let’s assume there are two parties ‘A’ and ‘B’. Both parties are under a contract that allows them to exchange the principal amount of loan along with the applicable interest rate in A’s native currency for a corresponding principal amount with the interest rate applicable to it in B’s currency.
In a typical currency swap scenario, the first party A borrows a definite amount of foreign currency from party B at a pre-determined foreign exchange rate.
During this period party A also lends a corresponding amount in its native currency to party B. Throughout the duration of the contract, both parties pay back at the exchange interest rate in the currency of the principal amount that was received.
Once the contract expires at a later date, both parties can repay the principal amount to each other.
Another good example would be a cross-currency swap between an American and European company. In which the American company borrows 1 billion EUR while lending 500 million USD to the European company with a pre-determined exchange rate of 2 EUR per USD indexed New York Interbank Rate after the initiation of the contract.
During the contract period, the American company will every so often receive interest payments from its European counterpart along with a basis swap price.
It will also be paying the European company in EUR at the interbank rate. After the expiration of the contract, the American company will pay 1 billion EUR back to the European company and receive its starting 500 million USD.
How Is A Currency Swap Beneficial?
Often times, it is not feasible to get desirable loans in foreign countries. For example, an institution or a business owner might have a hard time getting foreign loans at a desirable and low-interest rate.
In your native home country, however, it’s moderately easy to get loans with desirable interest rates as compared to foreign ones. Similarly, a foreign business owner might find it difficult to get similarly favorable terms in your native country.
Other countries can say the same for you. These situations create the perfect conditions for a currency swap. By signing a currency swap contract between yourself and a foreign business owner, both the parties can, in essence, take care of the loans for each other.
Afterward, they can swap these loans so that both parties receive the benefits of a lower interest rate.
It is very common for swaps to last for a long time based on the contract agreement. During this period, the exchange rate in the market will change drastically more often times than not.
To avoid this fluctuation in exchange rates, business owners or institutions lean towards currency swaps. By agreeing on a currency swap contract, they get to know the exact amount of how much money they will be receiving as well as how much they will be paying back in the future.
There are a variety of ways to pay the interest, such as paying at a floating rate, fixed-rate or even with the combination of two where one party pays at a floating rate while others pay at a fixed one.
Currency swap contracts are basically instruments used by corporations and businesses all over the world to counter the constant exchange rate variation in the market. They are usually used for medium to long term periods.
It is always important to learn about the forex market as much as possible as more knowledge of the trading environment will provide you with opportunities to earn interest from currency swaps.