What is a Currency Swap Contract?
A currency swap contract (also known as a cross-currency swap contract) is a derivative contract between two parties that involves the exchange of interest payments, as well as the exchange of principal amounts in certain cases, that are denominated in different currencies. Although currency swap contracts generally imply the exchange of principals, some swaps may require only the transfer of the interest payments.
Breaking Down Currency Swap Contracts
A currency swap consists of two streams (legs) of fixed or floating interest payments denominated in two different currencies. The transfers of interest payments occur on predetermined dates. In addition, if the swap counterparties previously agreed to exchange principal amounts, the amounts must also be exchanged on the maturity date at the same exchange rate.
Currency swaps are primarily used to hedge potential risks associated with fluctuations in currency exchange rates or to obtain lower interest rates on loans in foreign currency. The swaps are commonly used by companies that operate in different countries.
For example, a company may take a loan in domestic currency and enter a swap contract with a foreign company to obtain a more favorable interest rate on the foreign currency that is otherwise is unavailable.
How Do Currency Swap Contracts Work?
In order to understand the mechanism behind currency swap contracts, let’s consider the following example. Company A is a US-based company that is planning to expand its operations in Europe. Company A requires €850,000 to finance its European expansion.
On the other hand, Company B is a German company that operates in the United States. Company B wants to acquire a company in the United States to diversify its business. The acquisition deal requires US$1 million in financing.
Neither Company A or Company B holds enough cash to finance their respective projects. Thus, both companies can obtain the necessary funds through debt financing. Nonetheless, since borrowing in foreign currencies is costly due to high interest rates, Company A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a lower interest rate) and enter into the currency swap agreement with each other.
The currency swap between Company A and Company B can be designed in the following manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating interest rate of 6-month LIBOR. Then, the companies create a swap agreement with each other.
According to the agreement, Company A and Company B must exchange the principal amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the parties must exchange the interest payments semi-annually.
Company A must pay Company B the floating interest payments denominated in euros while Company B will pay Company A the fixed interest payments in US dollars. On the maturity date, the companies will exchange back the principal amounts at the same rate ($1 = €0.85).
Types of Currency Swap Contracts
Similar to the interest rate swaps, currency swaps can be classified based on the types of leg involved in a contract. The most commonly encountered types of currency swaps include the following:
- Fixed vs. float: One leg of currency swap represents a stream of fixed interest payments while another leg is a stream of floating interest payments.
- Float vs. float (basis swap): The float vs. float swap is commonly referred to as basis swap. In a basis swap, both swaps’ legs represent floating interest payments.
- Fixed vs. fixed: Both streams of currency swap contracts involve fixed interest rate payments.
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