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Home > Financial Risk Management Checklists > Understanding and Using Currency Swaps

Financial Risk Management Checklists

Understanding and Using Currency Swaps


Checklist Description

This checklist explains what a currency swap is and why it is used. Currency swaps are sometimes called cross-currency swaps.

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Definition

A currency swap is a foreign exchange transaction in which two or more parties agree to exchange a set amount of one currency for another for a specified period of time. At the end of the determined time-span, each party returns to the other the original sum swapped. Currency swaps are a useful tool for legitimately bypassing foreign exchange controls. Currency swaps are typically negotiated for any period of time up to 30 years’ maturity.

Under international accounting rules, a currency swap is not considered to be a loan and therefore does not usually appear on a company balance sheet. Rather, it is accounted as a foreign exchange transaction (the short leg), with the requirement to close the swap (the far leg) being accounted as a forward contract. All cash flows associated with the swap are paid—the initial receipt/payment of loaned principal, the payment/receipt of interest (in the same currency), and the ultimate return/recovery of the principal upon maturity.

It is not uncommon for a company to shop around to reduce the amount needed to service a debt. By borrowing at a lower cost in a particular currency and then exchanging it for a debt in the currency the company really desires, both parties can improve the condition of their debt while also maximizing their cash flows.

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Advantages

  • The main advantage of entering into a currency swap is its flexibility—the maturity of a swap is usually negotiable for at least 10 years. Entering into a currency swap can help both parties limit or manage their exposure to fluctuations in interest rates or to obtain a lower interest rate—a foreign company is unlikely to have access to better rates than a domestic company. As companies service their swap obligations with cash flow generated in a foreign currency, they thus also reduce their exchange rate risk exposure. An additional benefit to engaging in a currency swap is the reduction of counterparty risk, as evidenced by the bid–ask spread.

  • By definition currency swaps are also combined with an interest rate swap in two currencies. The terms of a swap may be drawn up to have fixed versus floating payments in different currencies beyond fixed rates.

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Disadvantages

  • Any benefit of entering into a currency swap must be balanced against the costs of the transaction and managing risks such the pre-settlement risk and the settlement risk. However, the chief risk in engaging in a currency swap is that the other party may fail to meet its obligations either during the period of the swap or upon maturity. Should one party wish to exit the swap before maturity, the exiting party must secure the consent of its counterparty before pursuing a mutually agreed exit strategy, much as in the case of selling an exchange-traded futures or option contract before maturity. Some exit routes include the following:

    1. Entering into an offsetting swap. For example, the exiting party could enter into a second swap, this time receiving a fixed rate and paying a floating rate.

    2. Selling the swap to a third party. As swaps have a calculable value, one party may sell the contract to a third party, with the permission of the counterparty.

    3. Purchasing a “swaption.” This allows a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap.

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Further reading

Books:

  • Hull, John C. Options, Futures, and Other Derivatives. 8th ed. Upper Saddle River, NJ: Pearson, 2011.
  • Redhead, Keith. Financial Derivatives: An Introduction to Futures, Forwards, Options and Swaps. London: Prentice Hall, 1996.
  • Walmsley, Julian. The Foreign Exchange and Money Markets Guide. 2nd ed. Wiley Frontiers in Finance Series. New York: Wiley, 2000.

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