As its name implies, a currency swap is the exchange of currencies between two parties.
While the idea of a swap by definition normally refers to a simple exchange of property or assets between parties, a currency swap also involves the conditions determining the relative value of the assets involved. That includes the exchange rate value of each currency and the interest rate environment of the countries that have issued them.
A Two-way Exchange
In a currency swap operation, also known as a cross currency swap, the parties involved agree under contract to exchange the following: the principal amount of a loan in one currency and the interest applicable on it during a specified period of time for a corresponding amount and applicable interest in a second currency.
Currency swaps are often used to exchange fixed-interest rate payments on debt for floating-rate payments; that is, debt in which payments can vary with the upward or downward movement of interest rates. However, they can also be used for fixed rate-for-fixed rate and floating rate-for-floating rate transactions.
Each side in the exchange is known as a counterparty.
In a typical currency swap transaction, the first party borrows a specified amount of foreign currency from the counterparty at the foreign exchange rate in effect. At the same time, it lends a corresponding amount to the counterparty in the currency that it holds. For the duration of the contract, each participant pays interest to the other in the currency of the principal that it received. Upon the expiration of the contract at a later date, both parties make repayment of the principal to one another.
An example of a cross currency swap for a EUR/USD transaction between a European and an American company follows:
In a cross currency basis swap, the European company would borrow US$1 billion and lend €500 million to the American company assuming a spot exchange rate of US$2 per EUR for an operation indexed to the London Interbank Rate (Libor), when the contract is initiated.
Throughout the length of the contract, the European company would periodically receive an interest payment in euros from its counterparty at Libor plus a basis swap price, and it would pay the American company in dollars at the Libor rate. When the contract comes to maturity, the European company would pay US$1 billion in principal back to the American company and would receive its initial €500 million in exchange.
The benefits for a participant in such an operation may include obtaining financing at a lower interest rate than available in the local market, and locking in a predetermined exchange rate for servicing a debt obligation in a foreign currency.
Currency swaps were first developed by financial institutions in the UK in the 1970s as a manner to circumvent currency controls imposed at that time by the government. The swap market was launched on a more formal basis in 1981, in a transaction in which the World Bank sought to reduce its interest rate exposure by borrowing dollars in the US market and exchanging them for Swiss franc and Deutsche mark debt obligations held by IBM.
Differences Between Currency Swaps And FX Swaps
Among types of swaps, the Bank for International Settlements (or BIS) distinguishes "cross currency swaps" from "FX swaps." Unlike in a cross currency swap, in an FX swap there are no exchanges of interest during the contract term and a differing amount of funds is exchanged at the end of the contract. Given the nature of each, FX swaps are commonly used to offset exchange rate risk, while cross currency swaps can be used to offset both exchange rate and interest rate risk.
Cross currency swaps are frequently used by financial institutions and multinational corporations for funding foreign currency investments, and can range in duration from one year to up to 30 years. FX swaps are typically used by exporters and importers, and institutional investors that seek to hedge their positions. and can range from one day to one year in duration, or longer.
According to the 2013 Triennial Central Bank survey from BIS, FX swaps were the most actively traded foreign exchange instruments, at upwards of US$2.2 trillion daily, or about 42% of forex-related transactions. Trading of cross currency basis swaps, by contrast, totalled an average of US$54 billion daily..
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