CURRENCY SWAPS

CURRENCY SWAPS
A currency swap is an agreement in which two parties
exchange the principal amount of a loan and the interest in
one currency for the principal and interest in another
currency.
At the inception of the swap, the equivalent principal
amounts are exchanged at the spot rate.
During the length of the swap each party pays the interest
on the swapped principal loan amount.
At the end of the swap the principal amounts are swapped
back at either the prevailing spot rate, or at a pre-agreed
rate such as the rate of the original exchange of principals.
Using the original rate would remove transaction risk on
the swap.
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Currency swaps are used to obtain foreign currency
loans at a better interest rate than a company could
obtain by borrowing directly in a foreign market or as a
method of hedging transaction risk on foreign currency
loans which it has already taken out.
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We will consider how a fixed for fixed currency swap
works by looking at an example.
An American company may be able to borrow in the
United States at a rate of 6%, but requires a loan in rand
for an investment in South Africa, where the relevant
borrowing rate is 9%. At the same time, a South African
company wishes to finance a project in the United States,
where its direct borrowing rate is 11%, compared to a
borrowing rate of 8% in South Africa.
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Each party can benefit from the other's interest rate
through a fixed-for-fixed currency swap.
In this case, the American company can borrow U.S.
dollars for 6%, and then it can lend the funds to the South
African company at 6%. The South African company can
borrow South African rand at 8%, then lend the funds to
the U.S. company for the same amount.
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Currency swaps can also involve exchanging two
variable rate loans, or fixed rate borrowing for variable
rate borrowing. Let’s consider a case where a company
exchanges fixed rate borrowing for variable rate
borrowing.
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Barrow Co, a company based in the USA, wants to
borrow €500m over five years to finance an investment in
the Eurozone.
Today’s spot exchange rate between the Euro and US $ is
€1·1200 = $1.
Barrow Co’s bank can arrange a currency swap with
Greening Co. The swap would be for the principal amount
of €500m, with a swap of principal immediately and in
five years’ time, with both these exchanges being at
today’s spot rate.
Barrow Co’s bank would charge an annual fee of 0.4% in
€ for arranging the swap.
The benefit of the swap will be split equally between the
two parties.
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The relevant borrowing rates for each party are as follows:
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We will see what the gain on the swap for each party will
be.
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The swap will then work as follows:
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The overall result show each party paying 0.6% less
than they would have paid in they had borrowed
directly in the foreign markets.
Barrow Co’s original principal amount of €500m would
be exchanged at the inception of the swap for
$446,428,517. The principal would be swapped back
five years later, at the end of the agreement, at the
original spot rate.
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