Currency swap

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A currency swap is a foreign-exchange agreement between two parties to exchange aspects

(namely the principal and/or interest payments) of a loan in one currency for equivalent aspects
of an equal in net present value loan in another currency; see Foreign exchange derivative.
Currency swaps are motivated by comparative advantage.[1] A currency swap should be
distinguished from a central bank liquidity swap.

Contents
[hide]

 1 Structure
 2 Uses
o 2.1 Hedging Example
 3 History
 4 References
[edit] Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.[1]

There are three different ways in which currency swaps can exchange loans:

The most simple currency swap structure is to exchange the principal only with the counterparty,
at a rate agreed now, at some specified point in the future. Such an agreement performs a
function equivalent to a forward contract or futures. The cost of finding a counterparty (either
directly or through an intermediary), and drawing up an agreement with them, makes swaps
more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term
forward exchange rates. However for the longer term future, commonly up to 10 years, where
spreads are wider for alternative derivatives, principal-only currency swaps are often used as a
cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.
[2]

Another currency swap structure is to combine the exchange of loan principal, as above, with an
interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the
counterparty (as they would be in a vanilla interest rate swap) because they are denominated in
different currencies. As each party effectively borrows on the other's behalf, this type of swap is
also known as a back-to-back loan.[2]

Last here, but certainly not least important, is to swap only interest payment cash flows on loans
of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in
different denominations and so are not netted. An example of such a swap is the exchange of
fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of
swap is also known as a cross-currency interest rate swap, or cross-currency swap.[3]

[edit] Uses
Currency swaps have two main uses:

 To secure cheaper debt (by borrowing at the best available rate regardless of currency and
then swapping for debt in desired currency using a back-to-back-loan).[2]
 To hedge against (reduce exposure to) exchange rate fluctuations.[2]

[edit] Hedging Example

For instance, a US-based company needing to borrow Swiss Francs, and a Swiss-based company
needing to borrow a similar present value in US Dollars, could both reduce their exposure to
exchange rate fluctuations by arranging any one of the following:
  If the companies have already borrowed in the currencies each needs the principal in,
then exposure is reduced by swapping cash flows only, so that each company's finance
cost is in that company's domestic currency.
 Alternatively, the companies could borrow in their own domestic currencies (and may
well each have comparative advantage when doing so), and then get the principal in the
currency they desire with a principal-only swap.

[edit] History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls
in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US
Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies
wishing to borrow Sterling.[4] While such restrictions on currency exchange have since become
rare, savings are still available from back-to-back loans due to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss
francs and German marks by exchanging cash flows with IBM. This deal was brokered by
Salomon Brothers with a notional amount of $210 million dollars and a term of over ten years.[5]

During the global financial crisis of 2008, the currency swap transaction structure was used by
the United States Federal Reserve System to establish central bank liquidity swaps. In these, the
Federal Reserve and the central bank of a developed[6] or stable emerging[7] economy agree to
exchange domestic currencies at the current prevailing market exchange rate & agree to reverse
the swap at the same exchange rate at a fixed future date. The aim of central bank liquidity swaps
is "to provide liquidity in U.S. dollars to overseas markets."[8] While central bank liquidity swaps
and currency swaps are structurally the same, currency swaps are commercial transactions driven
by comparative advantage, while central bank liquidity swaps are emergency loans of US Dollars
to overseas markets, and it is currently unknown whether or not they will be beneficial for the
Dollar or the US in the long-term.[9]

The People's Republic of China has multiple year currency swap agreements of the Renminbi
with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, and South Korea
that perform a similar function to central bank liquidity swaps.[10]