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Currency Swaps Explained
In finance, a currency swap, also known as cross-currency swap, is a legal contract between two parties to exchange two currencies at a later date, but at a predetermined exchange rate.
Usually, global banks operate as the facilitators or middlemen in a currency swap deal; but they can also be counterparties in currency swaps as a way to hedge against their global exposure, particularly to foreign exchange risk.
Benefits of Currency Swaps
Currency swaps have always been very convenient in finance. They allow for the redenomination of loans or other payments from one currency to the other.
This comes with various advantages for both individuals and companies. There is the flexibility to hedge the risk associated with other currencies as well as the benefit of locking in fixed exchange rates for a longer period of time.
For large corporations, currency swaps offer the unique opportunity of raising funds in one particular currency and making savings in another. The risk for performing currency swap deals is very minimal, and on top of that, currency swaps are very liquid, and parties can settle on an agreement at any time during the lifetime of a transaction.
Early termination of a currency swap deal is also possible through negotiation between the parties involved.
Examples of Currency Swaps
In the past, currency swaps were done to circumvent exchange controls, but nowadays, they are done as part of a hedging strategy against forex fluctuations. They are also used to reduce the interest rate exposure of the parties involved or to simply obtain cheaper debt.
For instance, let’s say a US-based company ‘A’ wishes to expand into the UK, and simultaneously, a UK-based company ‘B’ seeks to enter the US market. As international companies in their prospective markets, both companies are unlikely to be offered competitive loans.
UK banks may be willing to offer company A loans at 12%, while US banks can only offer company B loans at 13%. However, both companies could have competitive advantages on their domestic turfs where they could obtain loans at 8%.
If both companies are seeking similar amounts in loans, company A would borrow from its US bank, while company B would borrow from its UK bank. Company A and B would then swap their loans and pay each other’s interest obligations.
In the case of different interest rates, both companies would have to work out a formula that reflects their representative credit obligation.
Another way to approach the swap would be for both company A and company B to issue bonds at underlying rates. They would then deliver the bonds to their swap bank, who will switch them over to each other.
Company A will have UK assets, while company B will have US assets. Interest from company A will go through the swap bank that will deliver this to company B, and vice versa.
As well, each company will, at maturity, pay the principal amount to the swap bank, and in turn, they will receive the original principal.
In both scenarios, each company has obtained the foreign currency it desired, but at a cheaper rate while also protecting itself again forex risk.
In online forex trading, a swap is a rollover interest that you earn or pay for holding your positions overnight. The swap charge depends on the underlying interest rates of the currencies involved, and whether you are long or short on the currency pair involved.
If you open and close a trade within the same day, swap interest will not apply. Some of the high (positive) yielding currencies in forex include the Australian dollar (AUD) and New Zealand dollar (NZD); while low (negative) yielding currencies include the Japanese yen (JPY) and the euro (EUR).
Basically, if you buy a high yielding currency against a low yielding one, you will earn positive swap interest, but note that it can also go the other way around. There’s an option to avoid swaps whatsoever by opening a swap-free Islamic trading account.
Currency Swap main FAQs
What is the purpose of a currency swap?
In the case of swaps being made by businesses and institutions the reason currency swaps are done is typically as a hedge, or as a way to get cheaper financing. In the investing world a currency swap might be sought after by buying a high-yielding currency such as the Australian dollar, while simultaneously selling a low yielding currency like the Japanese Yen. So long as the movement in the pair is flat or advantageous to the trader, they can continue holding the pair while also collecting the swap, or the difference in interest rates between the two currencies.
What’s the greatest advantage of currency swaps for investors?
While using a currency swap as a way to generate income can be useful, the greatest advantage of a currency swap for retail investors is the ability to hedge against volatility in the currency markets. With a currency swap an investor can reduce the volatility in their overseas holdings, thus improving their risk-return profile and smoothing out the ups and downs in their portfolio. Because currency rates are always changing currency swaps can help to smooth out profits and losses in any portfolio.
What are the potential downsides to currency swaps?
There are a few negatives that can also be associated with currency swaps. In the case of an investor hedging their position, any positive movement in the currency will be muted in the results of the investment because the hedge is protecting from volatility in both directions. Those holding a position to collect the swap (such as AUD/JPY) could get wiped out by a sudden adverse movement in the currency pair. In the case of businesses doing swaps there is a credit and interest rate risk, particularly with swaps that stretch over several years.
In essence, a currency swap can be viewed at as an incentive to place long-term trades in the forex market. It is important to always learn about the markets as much as possible; because more knowledge translates to the ability to pinpoint the unlimited opportunities in forex trading.
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