Currency swaps are derivative contracts that involve the exchange of principal and interest in different currencies. Here’s what you need to know for those who operate in the stock market.
The currency swap market moves about $400 billion per day, representing 5% of the entire global forex market which is worth 8.1 trillion dollars. In fact, since the first currency swap transaction worth 100 million dollars between Mobil Oil Corporation and General Electric Corporation Ltd in 1981, this financial instrument has become fundamental to the global economy.
Currency swaps, as we will see, are agreements that allow two parties to exchange different currencies at a pre-established rate for a specified period. In particular, companies use this instrument to obtain more advantageous loan conditions than those offered by local banks. As demonstrated by the 2018 currency swap agreement between Japan and India, worth 75 billion dollars, these financial instruments can reach considerable dimensions and play a crucial role in international economic relations. Let’s try to better understand these contracts by analyzing their function, regulations and concrete examples.
What is a currency swap and how does it work?
First of all, a currency swap represents a financial contract between two parties who agree to exchange payment flows in different currencies. In particular, this agreement provides for the exchange of capital and interest denominated in two different currencies, with a pre-established exchange rate for a given period.
The exchange occurs through three main phases: the initial exchange of capital, periodic interest payments during the life of the contract, and finally the return of the capital at maturity. The interest rates applied can be both fixed, both variable, or one fixed and one variable, thus offering considerable flexibility in structuring the transaction.
The first currency swap contract was signed in 1981 between the World Bank and IBM. This agreement arose from the opposing needs of the two institutions: the World Bank was looking for low-interest funds in German marks and Swiss francs, while IBM wanted to convert its debt into dollars to benefit from the strengthening of the American currency.
Furthermore, currency swaps evolved from forms of parallel lending concluded between divisions of multinational groups operating in different countries. Today, these instruments represent a fundamental component of the financial market, although their volume is lower than interest rate swaps.
In the business context, currency swaps offer significant advantages, such as the possibility of:
- protecting operations from exchange risk;
- obtaining financing in foreign currencies at more advantageous conditions;
- effectively managing medium-long term currency exposure.
Types of Currency Swaps
Currency swaps are mainly divided into three categories, each characterized by different methods of exchanging interest rates. Let’s analyze each type in detail to understand their specific peculiarities and uses.
Fixed-for-Fixed Swap
- In this type, both parties undertake to exchange fixed-rate interest payments in different currencies. For example, a US company can borrow US dollars at a fixed rate of 8% and lend Australian dollars at a fixed rate of 9%. This type of swap is particularly advantageous when both parties are seeking stability in their cash flows and want to protect themselves from exchange rate fluctuations.
Fixed-for-Floating Swap
In this case, one party pays fixed interest in one currency while receiving floating interest in another currency from the other party. This structure allows companies to:
- modify an existing liability by transforming both the currency and the interest rate;
- create synthetic securities by combining features of different financial instruments;
- obtain an effective hedge against exchange rate risk.
Floating-for-Floating Swap
- This variant involves swapping floating rates in two different currencies. A practical example: if a company has a floating rate loan based on LIBOR in Japanese yen and an investment that yields TIBOR + 60 basis points, it could use this type of swap to protect itself from the risk of index fluctuations. Furthermore, these swaps allow companies to align their interest rate obligations with the prevailing market conditions in each currency.
Legal and regulatory aspects of currency swaps
The International Swaps and Derivatives Association (ISDA), on the other hand, provides the fundamental contractual framework for transactions in derivatives. The ISDA documentation establishes:
- standardized terms and conditions for transactions;
- dispute resolution procedures;
- management of counterparty credit risk.
Under the EMIR regulation, counterparties must ensure that information relating to concluded derivative contracts is transmitted to a trade repository.
Practical examples of currency swaps
One of the most significant examples in the history of currency swaps is the agreement signed in 1981 between the World Bank and IBM. The World Bank issued fixed-rate dollar bonds and exchanged the amount raised with IBM in exchange for German marks and Swiss francs, for a total value of 205,485,368 dollars. This agreement allowed the World Bank to access foreign currency financing at more advantageous rates, while IBM benefited from the elimination of exchange rate risk.
Later, during the 2008 financial crisis, the Federal Reserve established temporary swap lines with several central banks, including the ECB. In particular, when funding markets dried up due to extreme risk aversion, these agreements allowed banks in the euro area to obtain US dollars to finance their activities.
A more recent practical example concerns a private Italian company that obtained a €9.54 million loan. To protect itself from currency risk, the company entered into a euro/dollar currency swap with an exchange rate of €1.14/$. Through this contract, the company effectively transformed a floating-rate dollar loan into a fixed-rate euro loan.
Furthermore, in 2013, the ECB established a swap agreement with China, considering the country’s growing systemic importance and the expansion of trade between the two economies. This arrangement serves as a liquidity support mechanism, ensuring that euro area banks have access to Chinese renminbi even in the event of market disruptions.
Benefits and risks for companies
Currency swaps offer several strategic advantages for companies operating in international markets. First, they allow to stabilize cash flows and limit the impact of exchange rate fluctuations. In particular, companies can protect their liabilities from future increases in benchmark interest rates.
In short, the main benefits include:
- greater certainty on cash flows to stabilize income and expenditure;
- the possibility of obtaining more advantageous loan terms;
- protection against exchange rate fluctuations in international operations.
However, there are also significant risks to consider. Asymmetric information is one of the main critical issues, especially in the relationship between credit institutions and customers. In addition, swap contracts often contain implicit charges, i.e. fees that are not expressed during the negotiation phase.
A key aspect concerns the management of counterparty credit risk, which is particularly relevant in contracts that extend over multiple years. To mitigate these risks, many companies choose to hedge only a portion of their cash flows with forward transactions.
The basis for an effective approach is a clearly defined currency strategy that establishes which payment flows are hedged, to what extent and for what period of time. Typically, hedging occurs with a time horizon of up to 18 months, aligning with the planning of the next financial year of SMEs.
To optimize the benefits, companies must carefully quantify their overall exposure to currency risk, analyzing assets, liabilities, revenues and expenses denominated in foreign currencies. This assessment allows them to develop hedging strategies tailored to their specific business needs.
Original article published on Money.it Italy. Original title: Currency swap, cos’è, come funziona ed esempi per capire
