Updated Apr 13, 2022

What is a Currency Swap between Countries?

What is a Currency Swap between Countries?

An interest rate swap contract, also known as a currency swap contract, is a financial derivative agreement between two parties that includes the exchange of interest payments and, in some situations, the exchange of principal amounts between two currencies denominated in separate currencies. Contrary to the usual rule, currency swap contracts may not always need the exchange of principal amounts; in certain cases, the transfer of interest payments may be required.

Basics of the currency swap

First, currency swaps were used to avoid government restrictions on purchasing and selling currencies. For the most part, countries with strong and rising economies still use foreign exchange restrictions to keep a lid on currency speculation.

As a result, swaps are currently used most often to protect long-term assets and to alter the parties' respective interest rate risks. Companies that conduct business overseas often employ currency swaps to achieve better lending rates in the domestic currency than they would receive from a bank in that nation.

Breaking down the currency swap contacts

A currency swap comprises two interest payments (legs) denominated in two different currencies (fixed or variable). There are set dates for interest payments to be transferred. Aside from exchanging principal amounts, this also means exchanging them at the same rate on the maturity date if they were previously agreed upon.

For the most part, currency swaps are employed to protect against currency exchange rate volatility or cut the interest rate on foreign currency borrowing. Multinational corporations often make use of swaps. Instead of taking loans from a foreign bank, a corporation doing business overseas may employ currency swaps to get better loan terms in their home currency. It's possible to take out a loan with a lower interest rate in the local currency and then get into an agreement with a foreign firm to acquire a more advantageous interest rate in the foreign currency.

How does it Work?

Consider the following example to understand better how currency swap contracts work. Company A, headquartered in the United States, intends to develop its European operations. The European development of Company A necessitates an investment of €850,000.

While Firm A is based in the United States, Company B is a German corporation that operates in the United States. Firm B is looking to expand its business by acquiring a company in the United States. One million dollars in finance is needed for the purchase agreement.

Companies A and B do not have the necessary funds to fund their respective projects. As a result, both businesses plan to raise the money they need by taking out loans. Rather than borrowing in foreign currencies, companies A and B will want to borrow in their currencies and then engage in a currency exchange deal.

Here are some examples to create a currency exchange between companies A and B: 3.5 per cent fixed interest rate on a $1 million credit line from Bank A. Meanwhile, Bank B lends €850,000 to Company B at the 6-month LIBOR variable interest rate. The firms agree to enter into a swap arrangement.

Firms A and B are required by the agreement to trade the first main amounts ($1 million and €850,000). Semiannual interest payments are also required between the parties.

Floating rate interest payments are made by Company A to Company B in euros, while fixed-rate interest payments are made by Company B to Company A in US dollars. The corporations will swap the principal amounts back at the same rate ($1 = €0.85) at maturity (the end of the term).

Types of Currency Swap Contracts

For currency swaps, classification is similar to that of interest rate swaps in that it depends on the number of legs included in the contract. Exchanges between different currencies are most typically seen in the following forms:

• Fixed Vs. Float: An interest rate swap involves two streams of payments, one is tied to fixed rates of interest, and the other is tied to rates that fluctuate over time.
• Float vs Float: The basis swap is usually referred to as the float versus. Float exchange. In a basis swap, the legs of both swaps both reflect interest rate payments that are subject to change.
• Fixed Vs. Fixed: Fixed interest payments are made on both currency swap contracts.

For example, if a party agrees to pay a set interest rate on a CAD loan, they may exchange it for a fixed or variable interest rate in USD when undertaking a currency swap between USD and CAD. Another illustration would be the case of the variable exchange rate. A CAD loan with a floating interest rate may be exchanged for a USD loan with a floating or fixed interest rate. Quarterly or semi-annually, interest payments are computed.

How does it is priced?

LIBOR +/- spread is used to calculate pricing since it reflects the credit risk of the parties involved in the transaction. The London Interbank Offered Rate (LIBOR) is widely regarded as a reference point for large international banks when it comes to short-term borrowing. The spread is a result of the credit risk premium, which is based on the chance that the party would be able to repay the amount they had borrowed with interest.

Conclusion

In the world of banking, currency swaps have long been a popular and useful tool. It is possible to convert loans or other payments from one currency to another with these devices. Individuals and businesses alike may reap the benefits of this. The ability to mitigate currency risk, as well as the advantage of locking in fixed exchange rates for a longer length of time, is provided through the use of hedging instruments. With currency swaps, huge businesses may raise capital in one currency while saving money in another.