What is a Currency Swap?
Currency Swaps, useful for hedging interest rate risk, is an agreement between the two parties for exchanging notional amount in one currency with that of another currency and its interest rate can be fixed or floating rates denominated in two currencies. Such agreements are valid for the specified period only and could range up to a period of ten years depending upon the terms and conditions of the contract. As exchange of the payments takes place in the two different types of currencies so, spot rate prevailing at that time is used for calculating the amount of payment.
Types of Currency Swap
The classification can be done on the basis of different types of leg involved in the contract; the most common types are listed below
#1 – Fixed vs. Float
In this type, one leg represents the stream of payments for the fixed interest, while another leg represents the stream of payments for the floating interest.
#2 – Float vs. Float (Basis Swap)
This type is also known as the basis swap, where both legs of the swap represent the payments of floating interest.
#3 – Fixed vs. Fixed
In this type, both the stream of the swap represents the payments of fixed interest.
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For eg:
Source: Currency Swap (wallstreetmojo.com)
Examples of Currency Swap
Suppose there is an Australian company named A ltd., who is thinking of setting up the business in another country, i.e., the UK, and for that, it requires GBP 5 million when the exchange rate AUD/GBP is at 0.5. So that the total required amount in AUD comes to AUD 10 million. At the same time, there is a company U Ltd based out of the UK, who wants to set up a business in Australia, and for that, it requires AUD 10 million. Both the companies need loans for the six-monthly repayments. In both countries, there is high loan cost for foreign companies as compared with the local companies, and at the same time, it is also difficult to take a loan by the foreign companies due to the extra procedural requirements.
The cost of a loan in the UK for foreigners is 10%, and for locals, it is 6%, whereas in Australia, the cost of the loan for foreigners is 9% and for locals is 5%. Since both the companies can take the loan in their home countries at a low cost and easily, both decided to execute the currency swap agreement where A ltd took a loan of AUD 10 million in Australia, and U ltd took a loan of GBP 5 million in the UK and gave their amount of loan received to each other which enabled both of the firms to start their business in another country.
No, after every six months,
An ltd. will pay the interest portion to U ltd for the loan taken in the UK by U ltd which is calculated as follows:
U Ltd. will pay the interest portion to A ltd for the loan taken in Australia by A ltd, which is calculated as follows:
Like this payment against the interest will continue till the end of the currency swap agreement when both of the parties give back to other parties, their original foreign currency amounts are taken.
Advantages
- It helps the portfolio managersPortfolio ManagersA Portfolio Manager is an executive responsible for making investment decisions & handle investment portfolios for fulfilling the client’s investment-related objectives. Also, he/she works towards maximizing the benefits & minimizing the potential risks for clients. read more in regulating their exposure to the rate of interest prevailing.
- It helps in reducing the different costs and risks which are associated with the currency exchanges.
- Based on the existing economic situations, It helps the companies which are having the fixed-rate liabilities in capitalizing on the floating-rate swaps and the companies which are having the floating rate liabilities in capitalizing on the fixed-rate swaps.
- Speculators in the market can get benefit whenever there is any favourable change in the rate of interest.
- It helps in reducing the uncertainty, which is associated with future cash flows because the currency swap allows the companies to change their debt conditions.
Disadvantages
- Since any of the one party or both of the parties can default on the payment of interest or the principal amount, the currency swaps are exposed to the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more.
- There is a risk of the intervention of the central government in exchange markets. The same happens in case the government of a particular country acquires a huge amount of foreign debt in order to support their countries’ declining currency temporarily, which can lead to a huge downturn in the domestic currency’s value.
Important Points
#1 – There are three stages which form part of the currency swap. It includes spot exchange of the principal, Continuing exchange of the payment of the interest during the swap terms, and Re-exchange of the principal amount on the date of maturity.
#2 – The principal sum in currency swap is usually exchanged by the parties in one of the following manner:
- (i) At the start
- (ii) At the combination of the start and the end
- (iii) At the end
- (iv) neither
Conclusion
Thus the currency swap is the agreement between the two parties for exchanging the currencies at the terms and conditions predetermined between each other. The main motive of the currency swaps is to avoid various risks and turbulence in exchange rates and foreign exchange markets. Governments and the Central banks engage in the currency swaps with their foreign counterparts in order to ensure that adequate foreign currency is available at the time if there is any foreign currency scarcity.
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