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Economic Glossary

    Currency Swap

currency swap is a foreign-exchange agreement between two institutions to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency. Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

What are the main uses of Currency Swap?

Currency swaps have two main uses:

  • To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).
  • To hedge against (reduce exposure to) exchange rate fluctuations.

Bankers Algo Explains Currency Swap

For example, suppose a UK-based company needs to acquire Indian Rupee and a Swiss-based company needs to acquire U.K.  Pound Sterling. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. This is called Hedging

  • If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency.
  • Alternatively, the companies could borrow in their own domestic currencies (and may well each have Comparative advantage when doing so), and then get the principal in the currency they desire with a principal way swap

Currency swaps are over the counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

There are three different ways in which currency swaps can exchange loans:

1.      Exchange the principal value with the trading party at a specified point in the future at a rate agreed now. And this agreement often termed as forward contract. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap

2.      Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flow not netted before they are paid to the counterparty because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.

3.      Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross currency swap 


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Word of the day

Equivocate(v)

Meaning:

to use ambiguous or unclear expressions, usually to avoid commitment or in order to mislead; prevaricate or hedge

Synonyms: dodge, double-talk, elude, escape, eschew, evade, falsify, fence

Antonyms: face, meet, speak on

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