Currency vs. Interest Rate Swaps: An Overview
Swaps are derivative contracts between two parties that involve the exchange of cash flows. One counterparty agrees to receive one set of cash flows, while paying the other another set of cash flows. Interest rate swaps involve exchanging interest payments, while currency swaps involve exchanging an amount of cash in one currency for the same amount in another.
Interest Rate Swaps
An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest rate cash flows. The interest rate swap generally involves exchanges between predetermined notional amounts with fixed and floating rates.
For example, assume bank ABC owns a $10 million investment, which pays the London Interbank Offered Rate, or LIBOR, plus 3% every month. Therefore, this is considered a floating payment because as the LIBOR fluctuates, so does the cash flow. On the other hand, assume bank DEF owns a $10 million investment, which pays a fixed rate of 5% every month. Bank ABC decides it would rather receive a constant monthly payment. However, bank DEF decides to take a chance on receiving higher payments. Therefore, the two banks agree to enter into an interest rate swap contract. Bank ABC agrees to pay bank DEF the LIBOR plus 3% per month on the notional amount of $10 million. Bank DEF agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of $10 million.
As another example, Assume Paul prefers a fixed rate loan and has loans available at floating rate (LIBOR+0.5%) or at fixed rate (10.75%). Mary prefers a floating rate loan and has loans available at floating rate (LIBOR+0.25%) or at fixed rate (10%). Due to a better credit rating, Mary has the advantage over Paul in both the floating rate market (by 0.25%) and in the fixed rate market (by 0.75%). Her advantage is greater in the fixed rate market so she picks up the fixed rate loan. However, since she prefers the floating rate, she gets into a swap contract with a bank to pay LIBOR and receive a 10% fixed rate.
Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR from the bank. His net payment is 10.6% (fixed). The swap effectively converted his original floating payment to a fixed rate, getting him the most economical rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank, and receives 10% from the bank. Her net payment is LIBOR (floating). The swap effectively converted her original fixed payment to the desired floating, getting her the most economical rate. The bank takes a cut of 0.10% from what it receives from Paul and pays to Mary. (See related: How To Value Interest Rate Swaps.)
Conversely, currency swaps are a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.
For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in Russia and deals only with rubles. Suppose bank QRS has investments in the United States worth $5 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank DEF the LIBOR plus 1% per month on the notional amount of $5 million. Bank QRS agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of 253,697,500 Russian rubles, assuming $1 is equal to 50.74 rubles.
By agreeing to a swap, both firms were able to secure low-cost loans and hedge against interest rate fluctuations. Variations also exist in currency swaps, including fixed vs. floating and floating vs.floating. In sum, parties are able to hedge against volatility in forex rates, secure improved lending rates, and receive foreign capital.
- Swaps are derivatives contracts where one counterparty agrees to exchange cash flows with another.
- Interest rate swaps involve exchanging cash flows generated from two different interest rates - for example fixed vs. floating.
- Currency swaps involve exchanging cash flows generated from two different currencies to hedge against exchange rate fluctuations.