SWAPS

 Swap is an agreement between two parties

which exchange a predetermined sum of
foreign currencies with a condition to
surrender that sum on a pre decided date
 It always involves two simultaneous
operations: one spot and the other on a
future date
What is a Currency Swap?

 A currency swap is a foreign exchange

derivative
 They are over the counter derivatives
 It 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
TYPES OF CURRENCY SWAPS

 There are three different ways in which

currency swaps can exchange loans:
– To exchange only the principal with the
counterparty, at a rate agreed now, at some
specified point in the future
– To combine the exchange of loan principal, with
an interest rate swap
– To swap only interest payment cash flows on
loans of the same size and term
PRINCIPAL SWAP

 Performs a function equivalent to a Forward

Contract or Futures
 The cost of finding a counterparty and
drawing up agreement makes this more
costly
 This type of currency swap is also known as
FX-swap
PRINCIPAL & INTEREST SWAP

 In such a swap, interest cash flows are not

netted before they are paid to the
counterparty 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
INTEREST PAYMENT SWAP

 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
USES OF SWAP

 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
– To hedge against (reduce exposure to) exchange
rate fluctuations
HEDGING
 For instance, a US-based company needing to borrow Chinese
Yuan, and a Chinese-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
CROSS-CREDIT SWAPS

 There is an exchange of foreign currencies

between two parties
 American parent company----us dollar
loan---- Indian Bank----Indian rupee
loan--subsidiary--reimbursement in
Indian rupees---Indian bank--
reimbursement in US Dollars --American
parent company
BACK-TO-BACK CREDIT SWAPS

 Two companies located in two different countries

may agree to exchange loans in their respective
currencies for a fixed period
– Kodak USA-Lends in US Dollars -.Fuji USA
– Fuji Japan  Lends in Yen --- Kodak Japan
 The cost of swaps will depend on the rate of
interest and the exchange rate chosen by the two
parties