Currency swaps

A currency swap is a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time in accordance with a predetermined rule that reflects both interest payments and the amortization of the principal.Normally, fixed interest rates are used for each currency.In some cases, there is no exchange of principal amounts initially and at maturity.

Unlike the conventional foreign exchange swaps, which have been used in the foreign exchange market for a long time, currency swaps emerged as a financial instrument in the 1980s.In foreign exchange swaps, only the principal amount is exchanged when the transaction is initiated and again on the maturity of the contract.There is no exchange of interest payments in between these two dates.It is unfortunate, and perhaps confusing, that both kinds of transaction are referred to as “swaps”: no generally agreed terminology has appeared to distinguish between them.

Currency swaps have evolved as a successor to back-to-back loans or parallel loans.A parallel loan involves two counterparties lending each other loans of equal value, maturing on the same date and denominated in two different currencies.The exchange of the principal amounts is based on the spot rate, whereas the interest payments and the repayment of the principal are based on the forward rates.This kind of financial transaction was developed in the 1970s when exchange controls were in force in the United Kingdom.After the abolition of exchange controls in 1979, parallel loans continued to be used for the purpose of hedging long-term foreign currency exposure at a lower cost than can be obtained in the foreign exchange market.

Currency swaps differ from parallel loans in that the settlement of all payments is carried out on the basis of an exchange rate agreed upon when the contract is initiated.They normally involve an exchange of the principal amounts of the contract.Therefore, a currency swap consists of three stages, which can be illustrated by assuming two counterparties, A and B.Counterparty A has a comparative advantage in raising Australian dollar loans but needs Japanese yen funds, whereas B has a comparative advantage in raising Japanese yen loans but needs Australian dollar funds.The implication here is that A can raise Australian dollar loans at a lower rate than B, and vice versa.Thus, it makes a lot of sense if A raises Australian dollar loans while B raises yen loans and then they exchange (swap)the loans.Both, as a result, save on the cost of borrowing.The following stages are then involved in a currency swap:

1.The counterparties exchange the principal amounts at the commencement of the swap.A gives B Australian dollars and receives Japanese yen at a mutually acceptable exchange rate, which could be the spot exchange rate prevailing then.If the principal amount is K Australian dollars, then B receives this amount whereas A receives an amount equal to KS yen, where S is the exchange rate measured as JPY/AUD.

2.On the interest payment dates, A pays B the interest due on the yen loan, whereas B pays A the interest due on the Australian dollar loan.If i is the interest rate on the Australian dollar borrowing and i* is the interest rate on the yen borrowing, then A pays i* KS, whereas B pays iK on each interest payment date.These amounts, which are valued at the same exchange rate agreed upon at the beginning of the transaction, are channeled to the lenders.

3.On the maturity of the contract, the principal amounts are re-exchanged.Thus, A pays B an amount of KS yen, whereas B pays A an amount of K Australian dollars.These amounts are channeled to the lenders.Again, the same exchange rate is used.

If the principal amounts are not exchanged, then a currency swap resembles a portfolio of forward contracts: the two counterparties agree to exchange two cash flows denominated in two different currencies at a predetermined exchange rate on a sequence of dates in the future.