Currency Swap

Dr HK Pradhan
Professor of Finance & Economics
Why corporate use currency swap?

▪ Swap serves as a long term hedge tool

▪ Hedging currency risk (COS, POS)
▪ Matching currency assets and liabilities
▪ Locking in any gain accrued as on date
▪ ECB with a swap can serve as effective mechanism
USD-Euro Cross Currency Swap
Currency Swap
▪ An exchange of one currency against another
– An exchange of principal at the outset and a re-
exchange at maturity, or just a
– Current spot rate is normally used in both exchanges
– On-going interest payments are made based on spot
– Can be applied to new or existing debt
– Original liability remains intact
Example: Indian Company with a USD loan hedge
currency risk
 Example: Indian Company with a USD loan hedge

Euro
Receives
Euro
Citi Bank Company
$
$ LIBOR + $ Principal

Borrower

$ Repayment

▪ Swapping a USD loan to a Euro liability

An Indian Company having a USD loan wishes
hedge currency risk: Cash Flows Structure
▪ Swapping a USD loan to a INR liability

MIFOR
Bank Borrower
$ LIBOR
$ LIBOR+Spread
INR Principal
Bank Borrower
$ Principal
Repayment
▪ Swap rate is derived from MIFOR
▪ Coupon and Principal is fully hedged
 Currency Swap can be broken into COS & POS

COS POS

LIBOR+ Forward Premium ≈ MIFOR

Bank Borrower

$ LIBOR+Spread

Coupon only swap looks like long string of FX forward

contract
Principal Only Swap
▪ POS is exchange of principal amounts denominated in
two different currencies at a predetermined future date
– POS a corporate will switch USD principal liability to a Fixed INR
liability
▪ POS in economic terms is similar to long dated forward
contract instrument
▪ POS typically involves a periodic payment of swaps cost
(as opposed to forward contract where payment and
receipt of premium is done only at the settlement date)
 MIFOR Curve

The formula for Mifor computation is as follows:

Mifor = {[1 + Libor * No of Days / 360*100] * [1+USD/INR Forward Premia(%)
* No of Days / 365*100] - 1} * 365*100 / Total No of Days
MIFOR Swap
 Mumbai Interbank Forward Offer Rate - MIFOR
▪ MIFOR was a mix of the London Interbank Offer Rate (LIBOR) and a
forward premium derived from Indian forex markets
▪ Intention of MIFOR was for hedging purposes.
▪ However, many corporate entities used MIFOR for currency
speculation
▪ RBI banned MIFOR trade for corporate to curtail speculation
▪ RBI since allowed for MIFOR to be only used in interbank related
transactions
▪ Banks offer MIFOR based rates to foreign currency borrower/FCNR
loans, hedge on balance sheet

MIFOR computation:
Mifor = {[1 + Libor * No of Days / 360*100] * [1+USD/INR Forward Premia(%)
* No of Days / 36500] - 1} * 365*100 / Total No of Days
 MIFOR
Banks offer MIFOR linked rate to FC borrower
Derived from LIBOR + Forward Premium

MIFOR
Bank Company
LIBOR
LIBOR + Spread

▪ MIFOR reflects interest differential + risk premium

▪ MIFOR is configured to include currency exchange points
▪ The total impact represents the swap points
▪ It is also affected by the demand and supply conditions
Long Term FX Contract

▪ Outright forward liquid upto one year

▪ Beyond one year: liquidity issues
▪ Converges with interest rate parity/MIFOR based
▪ LTFX can be expensive beyond certain tenor
Currency Swap: Example
PRESENT POSITION
Outstanding debt : £ 100 million
Interest : 7%
Maturity : 5 years
Current Exchange Rate: $2.00/£

OBJECTIVE : Swap to $ liability, as the dollar is

expected depreciate.
Swap Terms : Principal : $200 MILLION
Interest : 10% p.a.
Maturity : 5 years
Currency Swap: Cash Flows
▪ 5-Year Swap terms
▪ £ 100 million @ 7% vs $200 million @ 10% p.a.
▪ Exchange rate $2.00/£

$200 M
$20 M $20 M $02 M $20 M $20 M

£7 M £7 M £7 M £7 M £7 M £100 M

Year 1 Year 2 Year 3 Year 4 Year 5 Year 5

 An example
The swap to receive £ and pay dollars is calculated in terms £:
Swap = P£ (6%) - P$ (8%)/ spot $/£

 7 7 7 107   20 20 20 220 
 1
+ 2
+ 3
+  −
4   1
+ 2
+ 3
+  / 1.9
4 
 (1.06) 1.06 1.06 1.06   (1.08) 1.08 1.08 1.08 

Swap Value = 103.46 – 213.24/1.9 = - £ 8.78 million

The dollar value of the swap is 8.78 * 1.9 = $ 16.67 million.
International
Conclusions

▪ The growth of the swap market has been astounding.

▪ Help to achieve desired asset-liability structure
▪ Swaps have become an important source of revenue
and risk for many banks & intermediaries
▪ Swaps are off-the-books transactions.
Thank You