Main Instruments - Currency Swaps

CURRENCY SWAPS

A currency swap is structurally different from the FX swap described above. In a typical currency swap,counterparties will (a) exchange equal initial principal amounts of two currencies at the spot exchange rate, (b) exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period of the swap, and then (c) re-exchange the principal amount at maturity at the initial spot exchange rate. Sometimes, the initial exchange of principal is omitted. Sometimes, instead of exchanging interest payments, a “difference check” is paid by one counterparty to the other to cover the net obligation.

The currency swap provides a mechanism for shifting a loan from one currency to another, or shifting the currency of an asset. It can be used, for example, to enable a company to borrow in a currency different from the currency it needs for its operations, and to receive protection from exchange rate changes with respect to the loan. The currency swap is closely related to the interest rate swap. There are, however, major differences in the two instruments.

An interest rate swap is an exchange of interest payment streams of differing character (e.g., fixed rate interest for floating), but in the same currency, and involves no exchange of principal. The currency swap is in concept an interest rate swap in more than one currency, and has existed since the 1960s.The interest rate swap became popular in the early 1980s; it subsequently has become an almost indispensable instrument in the financial tool box.

Currency swaps come in various forms. One variant is the fixed-for-fixed currency swap, in which the interest rates on the periodic interest payments of the two currencies are fixed at the outset for the life of the swap. Another variant is the fixed-for-floating swap, also called crosscurrency swap, or currency coupon swap, in which the interest rate in one currency is floating (e.g., based on LIBOR) and the interest rate in the other is fixed. It is also possible to arrange floating-forfloating currency swaps, in which both interest rates are floating.

Purposes of Currency Swaps

The motivations for the various forms of currency swap are similar to those that generate a demand for interest rate swaps. The incentive may arise from a comparative advantage that a borrowing company has in a particular currency or capital market. It may result from a company’s desire to diversify and spread its borrowing around todifferent capital markets, or to shift a cash flow from foreign currencies.

It may be that a company cannot gain access to a particular capital market. Or, it may reflect a move to avoid exchange controls, capital controls, or taxes. Any number of possible “market imperfections” or pricing inconsistencies provide opportunities for arbitrage. Before currency swaps became popular,parallel loans and back-to-back loans were used by market participants to circumvent exchange controls and other impediments. Offsetting loans in two different currencies might be arranged between
two parties; for example, a U.S. firm might make a dollar loan to a French firm in the United States, and the French firm would lend an equal amount to the U.S. firm or its affiliate in France.

Such structures have now largely been abandoned in favor of currency swaps. Because a currency swap, like an interest rate swap, is structurally similar to a forward, it can be seen as an exchange and re-exchange of principal plus a “portfolio of forwards”—a series of forward contracts, one covering each
period of interest payment. The currency swap is part of the wave of financial derivative instruments that became popular during the 1980s and ‘90s. But currency swaps have gained only a modest share of the foreign exchange business.

It has been suggested that the higher risk and related capital costs of instruments involving an exchange of principal may in part account for this result.4 In the 1998 global turnover survey, turnover
in currency swaps by reporting dealers was estimated at $10 billion per day. In the United States, turnover was $1.4 billion, well behind the United Kingdom—at $5 billion—and six other countries.