What to know about currency swap?
currency swap

What to know about currency swap?

Currency swaps are an increasingly common derivative in corporate debt capital structures. When organizations assess whether this product is right for their profile, they consider a variety of issues, from trade structuring to accounting treatment. Furthermore, the future of banking lies in securitization and diversification of credit portfolios. The global currency swap market will play a critical role in this transformation.

In this article, I present to you the essentials of what you need to know about currency swaps. But first, here is a paid training course that will allow you to get started with online training.

What is a currency swap?

A currency swap is an agreement between two parties to exchange the cash flows of a loan from one party for the other in a different currency. They allow companies to tap into global capital markets more efficiently because they provide a full arbitrage link between interest rates in different developed countries. A currency swap is simply an agreement to exchange cash flows in one currency for cash flows in another currency at set rates.

For example, a company may enter into an agreement with a hedging bank to receive a certain notional amount of USD at a fixed interest rate in exchange for paying a specified notional amount of EUR at a different interest rate. It is important to note that each leg of the transaction could be a fixed or floating rate.

Like any OTC derivative, these transactions are customizable. In some cases, there is an initial exchange of notional. For other cases, there is a final exchange of notional. In almost all cases, there are interim interest payments, which may or may not also include notional exchanges. The chart below provides a common example.

currency swap

The swap dates back to the 1960s when the FED (US central bank) intervened in the foreign exchange market to support the dollar by exchanging greenbacks for marks with the Bundesbank (the German central bank). The FED had then made the commitment that the reverse exchange (return of the marks and recovery of the dollars) would take place on a date fixed in advance.

Why use currency swap?

Swaps are used by some investors as speculative instruments to bet on the evolution of the prices of different markets. Thus you will find swaps on currencies, on rates, on shares, on raw materials, etc.

A swap must include elements such as a schedule, the duration, the start date, the value of the fixed rate, the nature of the underlying, the nominal amount, the basis of calculation and the reference of the variable rate.

Swap Example

Let's take the example of a U.S.-based company that we will call Acme Tool & Die. Acme raised funds by issuing a Swiss franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss francs. The company initially receives 100 million Swiss francs of the proceeds from the Eurobond issue (ignoring any transaction or other fees) and is able to use the Swiss francs to fund its U.S. operations.

Since this issue finances U.S.-based operations, two things will have to happen: Acme will have to convert the 100 million Swiss francs into U.S. dollars, and it would prefer to pay its liability for the coupon payments in U.S. dollars every six months. The company can convert this Swiss franc-denominated debt into U.S. dollar-like debt by entering into a currency swap with First London Bank.

He agrees to exchange the 100 million Swiss francs initially in U.S. dollars, as well as to receive coupon payments in Swiss francs on the same dates as coupon payments are due to Acme Eurobond investors and to pay coupon payments in U.S. dollars linked to an index and re-exchange the U.S. dollar notional amount into Swiss francs at maturity.

Acme's U.S. operations generate cash flows in U.S. dollars who pay the index payments in US dollars. In this way, the currency swap is used to hedge or lock in the added value of the Eurobond issuance, which is why these types of swaps are often negotiated as part of the entire issuance program with the main issuing financial institution.

Flexibility

Unlike interest rate swaps, which allow firms to focus on their comparative advantage by borrowing in a single currency in the short term, cross-currency swaps provide firms with additional flexibility to exploit their comparative advantage in their respective borrowing markets.

They also offer the opportunity to exploit advantages across a network of currencies and maturities. The success of the currency swap market and the success of the Eurobond market are explicitly linked.

The exhibition

Currency swaps generate greater credit risk than forward swaps. interest rate. This is because of the exchange and re-exchange of notional amounts. Companies must find the funds to deliver the notional at the end of the contract and are forced to exchange the notional of one currency for the other at a fixed rate. The more actual market rates deviate from this contractual rate, the greater the potential loss or gain.

This potential exposure is magnified as volatility increases over time. The longer the contract, the more room there is for the currency to move to either side of the agreed main exchange rate. This explains why currency swaps involve more lines of credit than traditional interest rate swaps.

The Price

Currency swaps are valued or priced in the same way as interest rate swaps. This is done using a discounted cash flow analysis that has obtained the zero-coupon version of the swap curves. Typically, a currency swap initially trades with no net value. Over the life of the instrument, the currency swap may go “in the money,” “out of the money,” or “out of the money.” out of the money " or it can stay " in the currency ».

Types of swaps

The instruments that are exchanged in a swap do not need to be interest payments. In fact, there are countless variations of exotic swap agreements. Relatively common agreements include currency swaps, debt swaps, commodity swaps, and total return swaps.

Interest Rate Swaps

The simplest and most common type of swap is known as a plain vanilla interest swap. In such a swap, Party A agrees to pay Party B a fixed, predetermined interest rate on a notional principal amount for a specified period of time on specific dates.

Therefore, Party B agrees to make any payment to Party A on a floating interest rate with the same notional principal for the same term on the same specified dates. In a classic interest rate swap, also known as a plain vanilla interest rate swap, the same currency is used to pay both cash flows. The payment dates that have been predetermined are called settlement dates, and the time between them is the settlement period. Since swaps are customized contracts, payments can be made monthly, quarterly, annually, or at any interval determined by the parties.

Example of an Interest Rate Swap

Consider two entities seeking to “artificially” convert their interest payment obligations. Company A might seek to exchange its floating interest payment obligation for a fixed rate that would allow it, for example, to obtain another loan. Its counterparty, Company B, might prefer to convert its payments to a floating rate, based on expectations that interest rates will decline.

currency swap

The currency swap

In a currency swap, two parties exchange principal and interest payments on a debt denominated in different currencies. Unlike an interest rate swap, the principal is often not a nominal amount but is instead exchanged with interest obligations. Currency swaps can take place in different countries.

For example, Argentina and China have used this swap, in particular so that China can stabilize its foreign exchange reserves.

As a second example, even the US Federal Reserve has engaged in an aggressive currency swap strategy with European central banks. This was done during the 2010 financial crisis in Europe, which aimed to stabilize the euro that was falling in the wake of the Greek debt crisis.

Currency Swap Example

The most iconic example of this type of swap was concluded in 1981, when the World Bank accepted a USD bond and then exchanged its dollar payment obligations with the American company IBM in exchange for hedging the company's debt issued in German marks (DM) and Swiss francs (CHF).

The swap allowed the World Bank to increase its exposure to the currencies of Switzerland and Germany, which had interest rates of between 8% and 12% compared with 17% in the United States - while IBM hedged its obligations in these currencies.

The Total Return Swap

In total return swap trading, the total return of a particular asset is swapped for a fixed interest rate. The party that will pay the fixed rate exposure on the underlying asset, whether it is a stock or an index. For example, an investor can pay a fixed rate to a party in exchange for capital appreciation, in addition to dividend payments from a pool of shares.

Commodity Swaps

The exchange of a floating commodity price is what is observed in a commodity swap. Take for example the spot price of Brent crude oil, for a price that is fixed over an agreed period. As the example suggests, a commodity swap will most often involve crude oil.

Debt-for-equity swaps

As the name suggests, a debt-for-equity swap involves exchanging equity for debt and vice versa. When it comes to a publicly traded company, this would mean exchanging bonds for shares. Debt-for-equity swaps are a way for a company to refinance its debt as well as relocate its capital structure.

The credit risk swap

Credit default swaps involve an agreement by a single party to pay the principal amount lost plus interest on a loan to the buyer of the credit risk, provided that the borrower defaults on the loan. Poor risk management and excessive leverage in the credit market were major causes of the 2008 financial crisis.

Example of a credit risk swap

Let us assume that in exchange for an attractive interest rate (underlying value), the pension fund "FP" has decided to invest by lending a large sum to ABC company. To mitigate its risk, FP (buyer) decides to open a credit default contract with an insurance company (issuer) in exchange for a fraction of the interest received on its investment. With this swap, FP manages to protect itself against the default (non-payment) of ABC company, by transferring the obligation to cover the losses to the insurance company.

Other types of swaps

  • The basis swap: allows you to exchange two variable rates indexed to short-term rates, in the same currency or in two different currencies
  • The constant maturity interest rate swap: makes it possible to exchange a variable rate indexed on short-term interest rates against another variable rate indexed on a medium or long-term interest rate.
  • The asset swap: it is the merger between an interest rate swap and a fixed rate bond creating a synthetic floating rate bond.
  • The total return swap: allows you to exchange the income and the risk of changes in the value of two different assets during a given period of time.
  • The inflation swap : the exchange of a fixed or variable rate against an inflation rate
  • Equity swaps: works in the same way as the interest rate swap
  • Curve Swap: interest rate swap (variable against variable) single currency betting on the shape of the yield curve.

Difference between currency swap and interest rate swap

An interest rate swap involves the exchange of cash flows related to interest payments on the designated notional amount. There is no exchange of notional at the beginning of the contract, so the notional amount is the same for both currency sides and it is denominated in the same currency. The principal exchange is redundant.

In the case of a currency swap, however, the exchange of principal is not redundant due to currency differences. The exchange of principal on notional amounts is done at market rates, often using the same rate for the transfer at the outset as that used at maturity.

The pros and cons of swaps

Swaps are used not only for hedging operations that aim to cancel or reduce the risk exposure of a company or an individual, but also for speculative operations. The major disadvantage of swaps remains linked to counterparty risk. It is indeed always possible that the counterparty will not meet its payment obligations. By opting for the swap for speculative purposes, you also risk suffering losses when your predictions are not good.

  • Flexibility is a significant advantage.
  • Another important benefit is financial optimization.
  • Risk management is the major advantage of swaps.
  • The operational costs are not negligible.
  • Lack of liquidity can be restrictive.
  • The complexity of contracts can be problematic.
  • Counterparty risk is a major concern.

Conclusion

Swap is a complex financial instrument that is mainly used by professional investors. This mechanism present on the foreign exchange market is also a derivative financial product that allows treasury operations and credit optimizations.

It is used by some traders to generate long term profits in forex by taking advantage of the interest rate differential between currencies through the strategy of " carry trade " However, individual investors are advised to seek to understand the basic mechanism by integrating it into your portfolio. But before we leave you, here is a premium training that will help you take charge of your personal finances.

I am a Doctor in Finance and an Expert in Islamic Finance. Business consultant, I am also a Teacher-Researcher at the High Institute of Commerce and Management, Bamenda of University. Group Founder Finance de Demain and author of several books and scientific articles.

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