What it means
A swap has three stages. At the start the two parties exchange principal amounts at an agreed rate, during the term they pay interest to each other in the currency they received, and at maturity they hand back the principal at the same starting rate.
The final exchange at the original rate is what removes exchange rate risk on the principal. No matter where the market rate has moved, each side gets back exactly the currency it started with, in the same amount.
Companies use swaps because of comparative advantage. A US firm may borrow cheaply in dollars but need euros to fund a European subsidiary, while a European firm has the opposite need, and a swap lets both borrow where they are best known and then trade the currencies.
Swaps are normally arranged through banks, which find a counterparty or take the other side themselves for a fee built into the rates. The agreement is a contract separate from the underlying loans, so the loans remain in place and the swap changes the effective currency of the cash flows.
The interest legs can be fixed against fixed, floating against floating, or fixed against floating (the last is called a cross-currency interest rate swap). The choice depends on whether the business wants to fix its financing costs or keep them linked to market rates.
The main risk is counterparty risk, which is the chance that the other side fails to meet its obligations. There is also an accounting cost, as swaps must usually be reported at fair value, and unless hedge accounting applies, their value changes can create volatility in reported profit.
In practice
Real-world examples.
Example
A US retailer opens stores in Germany and needs 20,000,000 euros. It borrows dollars at home and swaps them into euros, paying euro interest to its swap counterparty while its euro store revenue covers the payments.
Example
A Japanese manufacturer wants to build a plant in Texas and needs dollars. It swaps yen for dollars with a bank, so the dollar loan costs are matched with the dollar income from the plant.
Example
A multinational treasurer wants to convert a fixed-rate sterling bond into a dollar liability. A cross-currency swap turns the sterling coupons and principal into dollar payments, and the bond is effectively a dollar loan.
Formula
Calculation
Interest payment = principal in that currency x interest rate x time
Suppose a US company wants euros and a European company wants dollars. The spot rate is $1.1000 per euro, so they agree to swap $11,000,000 for 10,000,000 euros (10,000,000 x 1.1000 = $11,000,000).
Over a five-year term, the US company pays interest on the euros at 3%, which is 10,000,000 x 0.03 = 300,000 euros a year. The European company pays interest on the dollars at 5%, which is 11,000,000 x 0.05 = $550,000 a year.
At maturity, they swap back at 1.1000. If the market rate is then $1.2000, the 10,000,000 euros the US company returns would cost $12,000,000 in the market, but it only gives up the $11,000,000 it received at the start, so the fixed rate protected it from a $1,000,000 higher cost.Case study
Seen in the real world.
Calder Pharma is an illustrative, fictional drug distributor in the US that bought a small distributor in Spain for 15,000,000 euros. It funded the deal with a dollar loan because borrowing costs were lower at home.
The finance director noticed that the Spanish business earned only euros, while the loan repayments were in dollars. Any fall in the euro would reduce the dollar value of the profits used to repay the debt.
The company arranged a foreign currency swap with its bank for the term of the loan, which turned the dollar repayments into euro payments matched against euro earnings. In this illustrative case, the swap removed the mismatch, and the bank fee was treated as a financing cost rather than a trading loss.
Watch out
Common mistakes.
- Confusing a currency swap with a currency forward, when a swap involves exchanges at both the start and the end plus interest in between.
- Ignoring counterparty risk, when a bank failure or default could leave the business exposed again.
- Assuming a swap changes the original loan, when it is a separate contract that sits alongside it.
Questions
People also ask.
Are the principal amounts always swapped?
Most currency swaps exchange principal at the start and the end, but some skip the initial exchange and only exchange the final amount, depending on what the business needs.
How does a currency swap differ from an interest rate swap?
An interest rate swap exchanges only interest payments in one currency, while a currency swap involves two currencies and normally includes the principal.
Who uses currency swaps?
Multinational companies, banks, governments and development institutions use them to manage funding costs and to match the currency of debt with the currency of income.
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