Derivatives - Currency Swaps

Like an interest rate swap, a currency swap is a contract to exchange cash flow streams from some fixed income obligations (for example, swapping payments from a fixed-rate loan for payments from a floating rate loan). In an interest rate swap, the cash flow streams are in the same currency, while in currency swaps, the cash flows are in different monetary denominations. Swap transactions are not usually disclosed on corporate balance sheets.

As we stated earlier, the cash flows from an interest rate swap occur on concurrent dates and are netted against one another. With a currency swap, the cash flows are in different currencies, so they can't net. Instead, full principal and interest payments are exchanged.

Currency swaps allow an institution to take leverage advantages it might enjoy in specific countries. For example, a highly-regarded German corporation with an excellent credit rating can likely issue euro-denominated bonds at an attractive rate. It can then swap those bonds into, say, Japanese yen at better terms than it could by going directly into the Japanese market where its name and credit rating may not be as advantageous.

At the origination of a swap agreement, the counterparties exchange notional principals in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. At maturity, each makes a final exchange (at the same spot rate) of the initial principal amounts, thereby reversing the initial exchange. Generally, each party in the agreement has a comparative advantage over the other with respect to fixed or floating rates for a certain currency. A typical structure of a fixed-for-floating currency swap is as follows:
 

Calculating the Payments on a Currency Swap
Let's consider an example:

Firm A can borrow Canadian currency at a rate of 10% or can borrow U.S. currency at a floating rate equal to six-month LIBOR. Firm B can borrow Canadian currency at a rate of 11% or U.S. currency at a rate of floating rate equal to six-month LIBOR. Although Firm A can borrow Canadian currency at a cheaper rate than Firm B, it needs a floating-rate loan. Additionally, Firm B needs a fixed-rate Canadian dollar loan. The loan is for US$20 million, and will mature in two years.

Who has the comparative advantage?
To determine who has the comparative advantage, consider the fixed rates for each firm for the currency required. In this case, Firm A's rate of 10% is less than Firm B's rate of 11%, so Firm A has a comparative advantage in the fixed currency. That leaves Firm B to have a comparative advantage with respect to the floating rate.

Interest Rate and Equity Swaps


Related Articles
  1. Forex Education

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  2. Investing Basics

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  3. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  4. Trading Strategies

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  5. Forex Education

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  6. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  7. Investing

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  8. Bonds & Fixed Income

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  9. Trading Systems & Software

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  10. Economics

    Currency Swap Basics

    A currency swap involves two parties exchanging a notional principal and interest to gain exposure to a desired currency.
RELATED TERMS
  1. Foreign Currency Swap

    An agreement to make a currency exchange between two foreign ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  4. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
  5. Bond Market Association (BMA) Swap

    A type of swap arrangement in which two parties agree to exchange ...
  6. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
RELATED FAQS
  1. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
  2. What are the benefits of engaging in a currency swap?

    Read about the benefits of engaging in a currency swap, such as when companies in different countries want to borrow funds ... Read Answer >>
  3. What are some risks a company takes when entering a currency swap?

    Read about the risks associated with performing a currency swap, including counterparty credit risk in the event that one ... Read Answer >>
  4. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
  5. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  6. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center