currency-swaps-imageThis article provides a brief summary of Currency Swaps and their role as a financial product.

Defining Currency Swaps

Currency swaps can be described as interest rate swaps in different currencies, involving the exchange of principal amounts at inception and at maturity.

The Exchange of Principal at Inception and at Maturity

An interest rate swap is concerned exclusively with the exchange of cash flows relating to the interest payments on the designated notional amount. However, there is no exchange of notional at the inception of the contract. The notional amount is the same for both sides of the currency and it is delineated in the same currency. Principal exchange is redundant.

However, in the case of a currency swap, principal exchange is not redundant. The exchange of principal on the notional amounts is done at market rates, often using the same rate for the transfer at inception as is employed at maturity.

For example, consider the US-based company (“Acme Tool & Die”) that has raised money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss Francs. Up front, the company receives 100 million Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss Francs to fund their US operations.

Because this issue is funding US-based operations, we know two things right away: Acme is going to have to convert the 100 million Swiss Francs into US dollars, and Acme would prefer to pay its liability for the coupon payments in US dollars every six months.

Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering into a currency swap with the First London Bank.

Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the same dates as the coupon payments are due to Acme’s Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange the US dollar notional into Swiss Francs at maturity.

Acme’s US operations generate US dollar cash flows that pay the US-dollar index payments.

Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds. They are often negotiated as part of the whole issuance package with the main issuing financial institution.

Flexibility

Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets.

Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum.

Currency swaps allow companies to exploit advantages across a network of currencies and maturities.

The success of the currency swap market and the success of the Eurobond market are explicitly linked.

Exposure

Because of the exchange and re-exchange of notional principal amounts, currency swaps generate a larger credit exposure than interest rate swaps.

Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currency’s notional against the other currency’s notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain.

This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange.

This explains why currency swaps tie up greater credit lines than regular interest rate swaps.

Pricing

We price or value currency swaps in the same way that we learned how to price interest rate swaps, using a discounted cash flow analysis having obtained the zero coupon version of the swap curves.

Generally, currency swaps transact at inception with no net value. Over the life of the instrument, the currency swap can go “in-the-money,” “out-of-the-money” or it can stay “at-the-money.”

Advantages of Currency Swaps

Currency swaps allow companies to exploit the global capital markets more efficiently. They are an integral arbitrage link between the interest rates of different developed countries.

The future of banking lies in the securitization and diversification of loan portfolios. The global currency swap market will play an integral role in this transformation. Banks will come to resemble credit funds more than anything else, holding diversified portfolios of global credit and global credit equivalents with derivative overlays used to manage the variety of currency and interest rate risk.

- Article by Chand Sooran, Point Frederick Capital Management, LLC

Twitter: @csooran

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