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Currency swaps are an essential financial instrument utilized by banks, multinational corporations and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated. (Learn how these derivatives work and how companies can benefit from them. Check out An Introduction To Swaps.)

TUTORIAL: Introduction To The Forex Market

A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.

Let's back up for a minute to fully illustrate the function of a currency swap.

Purpose of Currency Swaps
An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from Brazilian banks' unwillingness to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favorable interest rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.

While the cost of borrowing in the international market is unreasonably high, both of these companies have a competitive advantage for taking out loans from their domestic banks. Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%. The reason for this discrepancy in lending rates is due to the partnerships and ongoing relations that domestic companies usually have with their local lending authorities. (This emerging market is making strides in regulation and disclosure. See Investing In China.)

Setting Up the Currency Swap
Based on the companies' competitive advantages of borrowing in their domestic markets, Company A will borrow the funds that Company B needs from an American bank while Company B borrows the funds that Company A will need through a Brazilian Bank. Both companies have effectively taken out a loan for the other company. The loans are then swapped. Assuming that the exchange rate between Brazil (BRL) and the U.S (USD) is 1.60BRL/1.00 USD and that both Companys require the same equivalent amount of funding, the Brazilian company receives $100 million from its American counterpart in exchange for 160 million real; these notional amounts are swapped.

Company A now holds the funds it required in real while Company B is in possession of USD. However, both companies have to pay interest on the loans to their respective domestic banks in the original borrowed currency. Basically, although Company B swapped BRL for USD, it still must satisfy its obligation to the Brazilian bank in real. Company A faces a similar situation with its domestic bank. As a result, both companies will incur interest payments equivalent to the other party's cost of borrowing. This last point forms the basis of the advantages that a currency swap provides. (Learn which tools you need to manage the risk that comes with changing rates, check out Managing Interest Rate Risk.)

Advantages of the Currency Swap
Rather than borrowing real at 10% Company A will have to satisfy the 5% interest rate payments incurred by Company B under its agreement with the Brazilian banks. Company A has effectively managed to replace a 10% loan with a 5% loan. Similarly, Company B no longer has to borrow funds from American institutions at 9%, but realizes the 4% borrowing cost incurred by its swap counterparty. Under this scenario, Company B actually managed to reduce its cost of debt by more than half. Instead of borrowing from international banks, both companies borrow domestically and lend to one another at the lower rate. The diagram below depicts the general characteristics of the currency swap.

Characteristics of a Currency Swap
Figure 1: Characteristics of a Currency Swap

For simplicity, the aforementioned example excludes the role of a swap dealer, which serves as the intermediary for the currency swap transaction. With the presence of the dealer, the realized interest rate might be increased slightly as a form of commission to the intermediary. Typically, the spreads on currency swaps are fairly low and, depending on the notional principals and type of clients, may be in the vicinity of 10 basis points. Therefore, the actual borrowing rate for Companyies A and B is 5.1% and 4.1%, which is still superior to the offered international rates.

Currency Swap Basics
There are a few basic considerations that differentiate plain vanilla currency swaps from other types of swaps. In contrast to plain vanilla interest rate swaps and return based swaps, currency based instruments include an immediate and terminal exchange of notional principal. In the above example, the US$100 million and 160 million reals are exchanged at initiation of the contract. At termination, the notional principals are returned to the appropriate party. Company A would have to return the notional principal in reals back to Company B, and vice versa. The terminal exchange, however, exposes both companies to foreign exchange risk as the exchange rate will likely not remain stable at original 1.60BRL/1.00USD level. (Currency moves are unpredictable and can have an adverse effect on portfolio returns. Find out how to protect yourself. See Hedge Against Exchange Rate Risk With Currency ETFs.)

Additionally, most swaps involve a net payment. In a total return swap, for example, the return on an index can be swapped for the return on a particular stock. Every settlement date, the return of one party is netted against the return of the other and only one payment is made. Contrastingly, because the periodic payments associated with currency swaps are not denominated in the same currency, payments are not netted. Every settlement period, both parties are obligated to make payments to the counterparty.

Bottom Line
Currency swaps are over-the-counter derivatives that serve two main purposes. First, as discussed in this article, they can be used to minimize foreign borrowing costs. Second, they could be used as tools to hedge exposure to exchange rate risk. Corporations with international exposure will often utilize these instruments for the former purpose while institutional investors will typically implement currency swaps as part of a comprehensive hedging strategy.

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