Currency Swap

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.

Currency-Swap

You are free to use this image on your website, templates etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
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:

Currency Swap Example 1

U Ltd. will pay the interest portion to A ltd for the loan taken in Australia by A ltd, which is calculated as follows:

Currency Swap Example 1-1

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

Disadvantages

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.

This has been a guide to what is currency swap and its definition. Here we discuss the types of currency swaps agreements along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –