Currency Swap

In finance, the term "swap" refers to an agreement that allows the parties to temporarily exchange any assets or liabilities. A swap operation is divided into two stages. At the first stage, a primary exchange of assets or liabilities is carried out, and at the second - a return, which is the closing of the transaction.

What Is a Currency Swap?

It is a combination of two opposite currency exchange transactions of the same amount with different value dates. In the case of a swap, the date of execution of a closer transaction is called the value date, and the date of execution of the more distant date of the reverse transaction is called the maturity date.

If the closest currency exchange transaction is the purchase of currency, and the more remote one is the sale of a currency, such a swap is called a buy and sell swap. If, in the beginning, a currency sales transaction is carried out, and the reverse transaction is the purchase of currency, this swap will be called a sell and buy swap.

A currency swap is typically conducted with one counterparty, that is, both currency exchange transactions are carried out with the same bank. This is the so-called pure swap. However, it is allowed to call a combination of two opposite currency exchange transactions with different valuation dates for the same amount concluded with different banks an engineered swap.

Currency swaps can be divided into three types:

• Standard (from a spot) - here the nearest value date is called a spot, the farthest one - a forward.

• Short one-day swaps (before the spot) - here both the dates of transactions included in the swap fall on the dates from the spot.

• Forward (after the spot) - a combination of two outright transactions, when a closer deal is concluded on a forward basis (value date later than spot), and the reverse transaction is concluded under a later forward condition.

Despite the fact that they represent currency exchange transactions by form, currency swaps belong to money market transactions by content.

Currency Swap Example

An American company has a subsidiary in Germany. To implement a 5-year investment project, it needs 30 million Euros. The spot exchange rate is EUR / USD 1.3350. The company has the ability to issue bonds in the United States in the amount of $40.05 million with a fixed interest rate of 8%. An alternative would be issuing bonds denominated in Euro, with a fixed rate of 6% + 1% (risk premium).

Suppose there is a company in Germany with a subsidiary in the United States, which needs a similar amount of investment. It can either issue bonds at 30 million euros at a fixed interest rate of 6%, or at 40.05 million dollars at 8% + 1% (risk premium) in the United States.

In any case, both companies are faced with significant currency risk, which will be subject to interest payments during the entire period of bond circulation.

In this case, the bank can organize a currency swap for these two companies. The bank will close long positions on currency purchases for both companies and reduce the cost of interest payments for both parties. This is due to the fact that each company takes loans in national currency at a lower percentage (without a risk premium). Thus, each company will benefit from the swap.

The principal amount of the loan will be transferred through the bank:

• USD 40.05 million – by the American company to the German subsidiary.

• EUR 30 Euro - by the German company to the American subsidiary.

Interest payments will be repaid as follows:

• German subsidiary annually transfers 30 x 0.06 = 1.8 million Euros to a parent company, which transfers these funds to a bank, which in turn transfers them to a German company to repay a loan in Euros.

• American subsidiary annually transfers $ 40.05 x 0.08 = $ 3.204 million to the parent company, which transfers these funds to the bank, which in turn transfers them to the American company to repay the loan in dollars.

Thus, a currency swap captures the rate three times:

1. Principal amounts of loans are exchanged at a spot rate of EUR / USD 1.3350.

2. The exchange rate for annual interest payments (from year 1 to year 4) will be fixed and amount to EUR / USD 1.7800 (USD 3.204 million / EUR 1.8 million).

3. The exchange rate at the time of paying off the interest payment for the fifth year and returning the principal amount of the loan will be EUR / USD 1.3602.

When making a transaction, the currency swap parties have fixed the exchange rate, which made it possible to avoid currency risks.