In a currency swap, the parties agree to swap equivalent amounts of currency for a period. This effectively involves the exchange of debt from one currency to another.
In a currency swap the two institutions involved in the swap could choose to exchange the principal or interest payments of a loan, or both, in one currency for equivalent amounts calculated in the net present value of another currency. They could enter into such an agreement to hedge exchange rate risk or for comparative advantage.
It should be noted that as with interest rate swaps, liability on the principal is not transferred and the parties are liable to counter party risk (i.e. risk that either party would fail to meet its own end of the bargain). If the other party defaults on the agreement to pay interest, the original borrower remains liable to the lender. This can present complicated legal problems, and some borrowers are unwilling to get involved in swap transactions for this reason.
The benefits are that the company can obtain interest rates which are lower than it could get from a bank of from other investors, and may be able to structure the timing of payments so as to improve the matching of cash flows with revenues. Swaps are easy to arrange and are flexible since they can be arranged in any size and are reversible. Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be paid.
- The benefit to the company is that it can gain access to debt finance in another country and currency where it is little known and consequently has a poorer credit rating than in its home country. It can therefore take advantage of lower interest rates than it could obtain if it arranged the loan itself.
- A further purpose of currency swap is to restructure the currency base of the company’s liabilities. This may be important where the company is trading overseas and receiving revenues in foreign currencies, but its borrowings are denominated in the currency of its home country. Currency swap therefore provides a means of reducing exchange rate exposure.
- A third benefit of currency swaps is that at the same time as exchanging currency, the company may be able to covert fixed rate debt to floating rate or vice versa. This it may obtain some of the benefits of an interest rate swap in addition to achieving the other purpose of a currency swap.
Interest rate swap
Interest rate swaps are transactions that exploit different interest rates in different markets for borrowing, to reduce interest costs for either fixed or floating rate loans. An interest rate swap is an agreement whereby two companies or a company and a bank, swap interest rate commitments with each other. In a sense, each stimulates the other’s borrowings with the following effects.
- A company which has debt at a fixed rate of interest can make a swap so that it ends up paying interest at a variable rate.
- A company which has debt at a variable rate of interest (floating rate debt) ends up paying a fixed rate of interest.
Note that the parties to a swap retain their obligations to the original lenders. This means that parties must accept contingent risk. Interest rate swaps have several further attractions. They include:
- They are easy to arrange
- They are flexible. They can be arranged in any size and, if required, reversed.
- The transaction costs are low, limited to legal fess
As with all hedging methods, interest rate swaps can alternatively be used as a means of financial speculation. In cases receiving much publicity, local authority treasurers have engaged in such speculation with disastrous results.
Among the various “hybrid” hedging instruments available which combine the features of different financial instruments in the swaption. What then is a swaption? A swaption is an instrument which is traded on a market in the writing or purchasing of options to buy an interest rate swap. For example, A ltd might buy a swaption from a bank, giving A ltd the right, but not the obligation, to enter into an interest rate swap arrangement with the bank at or before a specified time in the future.
Don M. Chance., Analysis of Derivatives