A foreign currency swap is an agreement between two parties to exchange interest payments on a loan in one currency for interest payments on a loan in another currency. Additionally, a swap can include exchanging the principal amounts, which are often swapped back when the agreement concludes. Generally, however, swaps involve notional principal amounts used to calculate interest without actually being exchanged.
Key Takeaways
- A foreign currency swap involves two parties swapping interest rate payments on respective loans in different currencies.
- Agreements can also encompass the swapping of principal amounts of loans.
- Primary types include fixed-for-fixed rate swaps and fixed-for-floating rate swaps.
- Helps companies secure loans at more favorable rates than local financial institutions offer.
- Can be used to hedge investments against exchange rate fluctuations.
Understanding Foreign Currency Swaps
One key purpose of engaging in a currency swap is to obtain loans in foreign currency at more favorable interest rates than might be available through direct borrowing in foreign markets.
During the 2008 financial crisis, the Federal Reserve allowed several developing countries experiencing liquidity issues the option to use currency swaps for borrowing purposes.
In 1981, the World Bank and IBM conducted the very first currency swap, whereby IBM exchanged German Deutsche marks and Swiss francs for U.S. dollars.
Currency swaps can be structured for loans with maturities stretching up to 10 years, distinguishing them from interest rate swaps which typically do not involve principal exchanges.
The Process of a Foreign Currency Swap
In a foreign currency swap, both parties pay interest on the other’s loan principal amounts throughout the agreement’s duration. Upon conclusion, if principal amounts were exchanged initially, they are swapped again either at the agreed-upon rate or the spot rate to avoid transaction risk.
Foreign currency swaps often depend on benchmark rates like the London Interbank Offered Rate (LIBOR), which international banks use for mutual borrowing. In 2023, the Secured Overnight Financing Rate (SOFR) will officially replace LIBOR for benchmarking purposes.
Types of Swaps
Fixed-for-Fixed Rate Swap
In a fixed-for-fixed rate currency swap, fixed interest payments in one currency are swapped for fixed interest payments in another.
Fixed-for-Floating Rate Swap
The fixed-for-floating rate swap involves exchanging fixed interest payments in one currency for floating interest payments in another. This type of swap generally does not involve exchanging the principal amounts of the underlying loan.
Reasons for Using Currency Swaps
Decreasing Borrowing Costs
A significant reason to utilize a currency swap is to secure cheaper debt. For example, European Company A might borrow $120 million from U.S. Company B, while concurrently, U.S. Company A borrows 100 million euros from European Company A. This exchange, at a $1.2 spot rate indexed to LIBOR, allows both companies to benefit from more favorable borrowing rates.
If principal exchange is involved, it will be exchanged again upon reaching the agreement’s maturity.
Reducing Exchange Rate Risks
Currency swaps also help institutions mitigate exposure to expected fluctuations in exchange rates. Companies conducting international business can hedge these risks by simultaneously taking opposing positions in each other’s currencies. This can help offset potential losses due to fluctuating exchange rates.
Why Do Companies Do Foreign Currency Swaps?
Foreign currency swaps provide companies access to potentially less expensive loans in foreign currencies and a way to hedge against risks arising from foreign exchange fluctuations.
What Are the Different Types of Foreign Currency Swaps?
Foreign currency swaps can involve fixed rate interest payments exchanges between currencies or fixed-for-floating rate interest payments exchanges. Agreements can also involve exchanging floating rate interest payments of both parties.
When Did the First Foreign Currency Swap Occur?
The first recorded instance of a foreign currency swap happened in 1981 between the World Bank and IBM Corporation.
Related Terms: currency swap, interest rate swap, hedging strategies, exchange rate, financial instruments.
References
- Federal Reserve System. “Credit and Liquidity Programs and the Balance Sheet”.
- The World Bank. “70 Years Connecting Capital Markets to Development”, Chapter 4.
- The Federal Reserve System. “Goodbye to All That: The End of LIBOR”.
