Currency Swaps

What is a currency swap?

A currency swap is really like a back-to-loan. This is where one party lends one currency and borrows another. During the life of the swap interest is paid and received on the currencies borrowed and lent. On maturity there is repayment.

The first transactions were in the 1970s where two companies exchanged their domestic currencies in order to borrow foreign currency often at an attractive interest rate.

Initially banks earned fees for arranging these deals but soon realised that they could act as a counterparty hedging the transactions through the evolving foreign exchange market.

Three types of currency swap

There are three standard types of currency swap.

1. Fixed/fixed currency swap. There is principal exchange at the start and at maturity. With interest being paid on both sides of the swap on a fixed rate basis:

2. Fixed/floating currency swap. There is principal exchange at the start and at maturity. With interest being paid on both sides of the swap, one side is on a fixed rate, one is floating rate:

3. Floating/floating currency swap. (These are also called currency basis swaps).There is principal exchange at the start and at maturity. With interest being paid on both sides of the swap on a variable rate basis, (normally Libor):

Principal Payments

As indicated above principal exchange normally occurs at the start and at the end of the transaction. The exchange rate used is the spot rate prevailing at the start of the transaction.

This is both for the initial and final exchange. (The forward rate is not used because the parties are paying and receiving the respective interest rates).

It should be noted that in some transactions principal exchange at the start may not take place and very occasionally no exchange occurs at the start and at maturity although this is rare.

Currency Swap Use

The currency swap market is relatively small. One of its main uses is to swap the proceeds of a bond issue from one currency to another.

For example a borrower could swap the proceeds from a EUR bond issue into GBP:

At the start the bond issuer receives the bond issue proceeds and exchanges these for GBP at the prevailing spot rate.

Interest is then paid in GBP and received in EUR before re-exchange of the principal amounts at maturity. The interest on the currency swap normally matches that on the bond coupon.

From the issuer’s (borrower’s) perspective the currency swap converts the issuance proceeds into the desired currency. The re-exchange at maturity means that there is no foreign exchange risk.

The rate of interest the bond issuer pays on the currency swap is largely determined by the interest received on the currency swap which in turn is dictated by the bond coupon.

Main Risks

One of the main risks in a currency swap is counterparty credit risk. This arises as a result of the re-exchange of principal on the maturity date at the original spot foreign exchange rate.

If the spot rate moves, as it is likely to, this forward transaction will have a positive value for one party and a negative value for the other. This credit exposure can be large.

It is one of the reasons why currency swaps are subject to collateral management or alternatively from time-to-time the principal amounts are re-adjusted in line with the prevailing spot foreign exchange rate.

First Published by Barbican Consulting Limited 2014