Currency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly. However, since these types of swaps involve an exchange of two currencies, an exchange rate, generally the prevailing spot rate is used to calculate the amount of cash flows, apart from interest rates relevant to these two currencies. By its special nature, these instruments are used for hedging risk arising out of interest rates and exchange rates.
Definition: A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.
Consider a swap in which:
Bank UK commits to pay Bank US, over a period of 2 years, a stream of interest on USD 14 million, the interest rate is agreed when the swap is negotiated; in exchange, Bank US commits to pay Bank UK, over the same period, a counter stream of sterling interest on GBP 10 million; this interest rate is also agreed when the swap is negotiated. Bank UK and Bank US also commit to exchange, at the end of the two year period, the principals of USD 14 million and GBP 10 million on which interest payments are being made; the exchange rate of 1.4000 is agreed at the start of the swap.
We can now see from the above that currency swaps differ from interest rate swaps in that currency swaps involve:
- An exchange of payments in two currencies.
- Not only exchange of interest, but also an exchange of principal amounts.
- Unlike interest rate swaps, currency swaps are not off balance sheet instruments since they involve exchange of principal at the end of the period.
- The idea of entering into the currency swap is that, Bank US is probably expecting an amount of GBP 10 million at the end of the period, while Bank UK is expecting an amount of USD 14 million, which they agreed to exchange at the end of the period at a mutually agreed exchange rate.
- The interest payments at various intervals are calculated either at a fixed interest rate or a floating rate index as agreed between the parties.
- Currency swaps can also use two fixed interest rates for the two different currencies – different from the interest rate swaps.
- The agreed exchange rate need not be related to the market.
- The principal amounts can be exchanged even at the start of the swap
If in the above-mentioned swap, the two banks agree to exchange the principal at the beginning.
Types of Currency Swaps:
- Bank UK will sell GBP to Bank US in exchange for US Dollars.
- This would be at an exchange rate, most likely the spot rate.
- These banks would borrow the respective currencies, which they have sold.
- But at maturity, this exchange of principal would be reversed at the original exchange rate. (This kind of swap is called a par swap).
Cross-currency coupon swaps:
These are fixed-against-floating swaps.
Cross-currency basis swap:
These swaps involve payments attached to a floating rate index for both the currencies. In other words, floating-against-floating cross-currency basis swaps.
Risk Management with currency swaps:
Example: (Principal exchanged at Maturity)
A UK Co. With mainly sterling revenues, has borrowed fixed-interest dollars in order to purchase machinery from the U.S. It now expects the GBP to depreciate against the USD and is worried about increase in its cost of repayment.
It could now hedge its exposure to a dollar appreciation by using a GBP/USD currency swap. It would fix the rate at which the company, at maturity, could exchange its accumulated sterling revenues for the dollars needed to repay the borrowing. Fixing the exchange rate hedges the currency risk in borrowing dollars and repaying through sterling.
Assuming, the Company expects not only the dollar to appreciate, but also the GBP interest rates to fall. It could take advantage of this situation, by swapping from fixed-interest dollars into floating interest sterling.
Example: (Principal exchanged at the beginning)
- At the start of the swap, the GBP/USD rate is agreed at which the principal amounts will be exchanged at maturity (probably, the prevailing GBP/USD spot rate)
- At the same time, interest rates for use in the swap are also agreed
- Over the life of the swap, the UK Company will pay a stream of sterling floating interest through the swap and will receive a counter stream of dollar fixed interest in exchange. The dollar interest received through the swap will be used to service the dollar borrowing; the sterling interest paid through the swap will be funded from earnings.
- At maturity, the company will pay a sterling principal amount through the swap and receive a dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed at the start of the swap. The company will fund its payment of principal through the swap from accumulated sterling earnings from its business and will use the dollar principal it receives in exchange to repay its dollar borrowing.
This will be the case when the UK co. wants to swap its dollar loan into a sterling loan, but needs dollars at the outset to pay for dollar imports or for any other purpose. In this case, the UK co. would simply acquire the dollars from the spot foreign exchange market. It would fund this spot purchase of dollars with the sterling received through the swap in the initial exchange of principal amounts.
- At the start of the swap, the UK co. buys dollars against sterling in the spot market.
- The dollar bought in the spot are exchanged through the swap for sterling, at the same GBP/USD exchange rate at which the UK co. had to buy dollars against sterling in the spot market; the sterling received through the swap is used to fund the spot purchase of the dollars.
- At the same time, the GBP/USD rate at which the principal amounts will be exchanged at maturity is fixed at the spot rate at which the UK co. had to buy dollar against sterling in the spot.
- The interest rates for use in the swap are also agreed;
- Over the life of the swap, the UK co. will pay a stream of sterling interest through the swap and will receive a counter stream of dollar interest in exchange. The dollar interest received will be used to service to the dollar borrowing; the sterling interest paid through the swap will be funded from earnings.
- At maturity, the co. will pay a sterling principal amount through the swap and receive a dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed at the start of the swap. The co. will fund its payment of principal through the swap from accumulated sterling earnings from its operations and will use the dollar principal, it receives in exchange, to repay its dollar borrowing.
Swap Market in India.
In India, the Reserve Bank of India has permitted banks to arrange currency swaps with one currency leg being Indian Rupee. However, the USD/INR forward foreign exchange markets are illiquid beyond one year. Since currency swaps involve the forward foreign exchange markets also, there are limitations to entering the Indian Rupee currency swaps beyond twelve months. Moreover, banks are also not allowed to take risk /run open swap books i.e., they have to locate counter parties with matching requirements; e.g. one desiring to swap a dollar liabilities into rupee liabilities and the other wishing to exchange rupee debt servicing obligation for dollar obligations. However, some aggressive banks do provide quotes for currency swaps for three to five years out for reasonable size transactions.
Corporates who have huge rupee liabilities and want have foreign currency loans in their books, both as a diversification as well as a cost reduction exercise could achieve their objective by swapping their rupee loans into foreign currency loans through the dollar/rupee swap route. However, the company is assuming currency risk in the process and unless carefully managed, might end up increasing the cost of the loan instead of reducing it. In India, it is more the norm for corporates to swap their foreign currency loans into rupee liabilities rather than the other way round.
A corporate has a loan of USD 10 million outstanding with remaining maturity of 2 years, interest on which is payable every six months linked to 6-month Libor + 150 basis points. This dollar loan can be effectively converted into a fixed rate rupee loan through a currency swap.
If the corporate wants to enter into a currency swap to convert his loan interest payments and principal into INR, he can find a banker with whom he can exchange the USD interest payments for INR interest payments and a notional amount of principal at the end of the swap period. The banker quotes a rate of say 10.75% for a USD/INR swap. The total cost for the corporate would now work out to 12.25%. If the spot rate on the date of transaction is 44.65, the rupee liability gets fixed at Rs. 446.50 mio. At the end of the swap, the bank delivers USD 10 million to the corporate for an exchange of INR 446.50 mio, which is used by the corporate to repay his USD loan. The corporate is able to switch from foreign currency.