Currency Swaps Meaning, Types and Examples

Currency swaps or cross-currency swaps is a transaction in which two parties exchange an equivalent amount of money with each other. However, this transaction occurs in different currencies. Parties loan each other money and repay this amount at a specified date and exchange rate. Mostly financial institutions are involved in currency swaps. These institutions may trade on their own or on behalf of a non-financial corporation. 

Table of Contents

• Currency Swaps Meaning
• Types of Currency Swaps
• Where Are Currency Swaps Traded?
• How Does Currency Swap Work?
• Advantages of Currency Swaps
• Disadvantages of Currency Swaps

Currency Swaps Meaning

Currency swaps is a transaction between two financial institutions that occurs in different currencies. It is a financial instrument used by companies and institutions to secure better loan rates in foreign currencies than they might be able to obtain directly in the foreign market. They involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency between two parties.

Types of Currency Swaps

Currency swaps come in various types, each tailored to meet specific needs and objectives. Following are the main types of currency swaps:

1. Fixed-for-Fixed Currency Swap: Both parties exchange interest payments and principal in different currencies at fixed interest rates. This is the most straightforward type of currency swap, ideal for hedging against currency and interest rate risks.
2. Fixed-for-Floating Currency Swap: One party pays a fixed interest rate on a specified currency, while the other pays a floating interest rate on another currency. This type is useful for companies looking to hedge against or speculate on interest rate movements.
3. Floating-for-Floating Currency Swap (Basis Swap): Both parties exchange interest payments in different currencies, but both are floating rates. This swap is often used when both parties seek to benefit from differing expectations of future interest rate movements in their respective currencies.
4. Principal Only Swap: Involves only the exchange of the principal amounts in two different currencies at the beginning and end of the agreement, without any exchange of interest payments. This can be useful for companies needing to convert a loan in one currency to another currency for a specific period.
5. Interest Only Swap: Only interest payments are exchanged in different currencies according to the agreed terms, without any exchange of the principal amounts. This type can be advantageous for managing cash flows and hedging against interest rate fluctuations.
6. Amortizing Swap: The principal amount decreases over time according to a predetermined schedule. This swap is suitable for companies with loans that are being paid down over time, as it can help match their debt repayment schedules.
7. Accreting Swap: Opposite of an amortizing swap, the principal amount increases over time. This can be useful for projects with increasing financing needs over time.
8. Cross-Currency Interest Rate Swap: It is a combination of interest rate swap and currency swap, where one party swaps the interest payments and principal in one currency (either fixed or floating) for payments in another currency (either fixed or floating). It's utilized f or obtaining better loan rates and hedging against both interest rate and currency risks.

Where Are Currency Swaps Traded?

These are over-the-counter (OTC) financial instruments that are not traded over any centralized exchange. These currency swaps are negotiated between two parties. These are held by two parties to the contract. In some cases, one or both the parties may sell or transfer its position to another party. Such transfers are subject to the consent of the other party and may incur additional fees or restrictions.

How Does Currency Swap Work?

During a currency swap, parties agree in advance whether they will or will not exchange the principal amounts of two currencies at the beginning of a transaction. The exchange rate depends on the two principal amounts. During maturity, the same principal amounts must be exchanged. 

Working of Currency Swaps Contract With an Example

Let us take a look at an example to illustrate how currency swaps work:

Situation:

• Company A is based in the United States and wants to borrow euros.
• Company B is based in Europe and wants to borrow U.S. dollars.
• Both companies find that they can get better interest rates by borrowing in their home currencies than in foreign currencies directly.

Step 1: Initial Exchange

• Company A and Company B agree to a currency swap.
• Company A borrows an agreed amount in U.S. dollars at the prevailing interest rate in the U.S., say $10 million at 3% annual interest.
• Company B borrows the equivalent amount in euros at the prevailing interest rate in Europe, say €9 million at 2% annual interest.
• They then swaps the principal amounts, meaning Company A receives €9 million, and Company B receives $10 million.

Step 2: Interest Payments

• Throughout the term of the swap, Company A will pay the interest on the €9 million at 2% to Company B, even though the money was originally borrowed in dollars.
• Similarly, Company B will pay the interest on the $10 million at 3% to Company A.
• These payments are usually netted against each other to simplify the transaction.

Step 3: Principal Exchange

• At the end of the swaps agreement, which could be several years later, the principal amounts are swapped back at the same exchange rate as the initial transaction, regardless of any fluctuations in the currency rates in the meantime.
• This means Company A returns €9 million to Company B, and Company B returns $10 million to Company A.

Benefits:

• Company A gets access to euros at a cheaper interest rate than if it borrowed directly in the euro market.
• Company B gets access to dollars at a cheaper interest rate than if it borrowed directly in the U.S. market.
• Both companies benefit from the certainty of knowing their future cash flows in terms of foreign currency payments and receipts, which helps in hedging against currency risk.

Advantages of Currency Swaps

Currency swaps offer several benefits for companies and financial institutions, including:

• Access to Better Rates: Companies can borrow at more favourable interest rates in their home currency and swaps to obtain foreign currencies, potentially saving on interest costs.
• Hedge Against Currency Risk: Currency swaps provide a hedge against exchange rate fluctuations by locking in exchange rates for the repayment of principal and interest payments.
• Improved Loan Access: They enable access to foreign capital markets that may otherwise be inaccessible due to regulatory barriers or high borrowing costs.
• Flexibility in Financing: Companies can tailor the terms of currency swaps to meet their specific financial needs, including the amount, term, and interest rate structure.
• Balance Sheet Management: Swaps can be used to manage and optimize the currency composition of a company's balance sheet, reducing foreign exchange exposure.
• Cost Efficiency: By netting out interest payments, companies can reduce transaction costs associated with currency exchanges and interest payments.
• Liquidity Management: They help companies manage liquidity by providing access to additional funding sources in different currencies.
• Strategic Expansion Support: Currency swaps can support companies' international expansion strategies by providing a mechanism to finance investments in foreign countries efficiently.

Disadvantages of Currency Swaps

Currency swaps have the following disadvantages:

• Complexity: They can be complicated to structure and understand, requiring specialized knowledge.
• Credit Risk: Risk that the other party might not fulfill their payment obligations.
• Market Risk: Exposure to the fluctuation in interest rates and currency values that can affect costs.
• Liquidity Risk: Difficulty in finding a counterparty or exiting the swaps can pose challenges.
• Operational Costs: Involves legal, consulting, and monitoring expenses, increasing the overall cost.
• Regulatory Risk: Subject to varying regulations that can change, potentially affecting the swap's viability.
• Opportunity Cost: Locking in rates may result in missed opportunities if market conditions improve.
• Settlement Risk: Risk at the end of the swap, especially if there's a significant movement in exchange rates.