How Currency Swaps Work

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A currency swap (cross currency swap) is a financial derivative in which two parties exchange interest and principal payments in different currencies. A currency swap is similar to an interest rate swap, which however, entails payments being exchanged in the same currency.

There are two legs to a currency swap, and these involve short legs (runs for two days) and the long legs (runs typically with a value of between one week to a year).

A swap is used for example if a company needs US dollars, the firm thus enters into a swap agreement with a major bank where the company receives the dollars. And will deliver the money bank to the bank after two days (short leg), or longer (long leg).

The bank typically quotes two courses at closing (course for the short leg and a second path for the long leg). The difference between the two courses is referred to as swap points, and expresses interest rate differential between two currencies.

Swaps were first used in the early 80s and, in particular for longer protection periods as compared to other backup options which are often a cheaper alternative.

At the start of an exchange of capital the deal is based on the current spot price, and will be changed at regular intervals during the term. In each contract a party is charged in the currency in which he has received the principal amount. And in each of the two currencies fixed or variable interest is applied.

On maturity the principal amount will be changed back, effected at the same rate as in the exchange of capital. Hence, this is in contrast to the forward foreign exchange contract, due to varying interest rates. The reasons for such deviations from the futures spot price, are already taken into account by the obligations of exchange of interest.

Currency swaps provide a greater market depth (liquidity) due to a smaller number of transactions and constitutes a real alternative to forward exchange contracts. For reasons of legal certainty currency swaps are normally concluded under framework contracts.

Swap transactions are achieved either by direct negotiation of the potential contract partner or through the interposition of banks as a contractor. Banks play a significant role in the trading of swaps, because on the one hand, they assume the role of the mediator and on the other undertake an active part in the actual transactions.

In the event that the bank is an active partner in the swap transaction, it takes a position at their own risk with a corresponding swap. And when the bank acts as an intermediary, it is to distinguish between the open and anonymous communication. In the open arrangements the bank brings together the two parties for a planned swap transaction, and negotiate.

The risk of the swap transaction entered into are borne exclusively by the two parties involved. This credit risk is reduced if necessary, and it is the swap partners’ responsibility to thoroughly assess it. An anonymous placement of a swap is therefore of particular interest to the parties as regards the creditworthiness of both the business swap market participants involved.
 

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